Good News: Bull Market Continuation Signal Given
June 22, 2010
I have a confession to make; I am an indicator junkie. I have been involved with the game of trading/timing the stock market since 1980 and as such, looking at various indicators of the market’s health, likely direction, buy and sell signals, etc. has become one of my favorite pastimes.
Getting directly to the point, I’ve come across a long-term market signal that I believe is a fairly reliable “bull market continuation” signal (except, of course, when it is not!).
The idea is fairly simple, which, as experience has taught me, is a good thing. Remember, an indicator doesn’t have to include pages of algorithms in order to work consistently. So here goes… As a bull market begins, the market will usually move higher for an extended period of time without so much as even a -8% correction. The most recent example of this has been the move off of the March 9, 2009 low.
Eventually though, the market succumbs to a corrective phase, or in some cases such as this one, a series of corrections, that takes the wind out of the bulls sails. Such corrective phases cause investors to question the big-picture outlook and to wonder if the bulls are still in charge.
This corrective phase can also be seen from a technical perspective. If one tracks the percentage of stocks above their 200-day moving averages (which is a commonly accepted definition of a stock’s technical health), we find that when bull markets begin, we usually see the percentage of stocks above their 200-day exceed 90%. In English, this tells us that with more than 90% of stocks in a technically healthy position, it is safe to say that the bulls are “large and in charge.”
However, as the bull market progresses, the number of stocks above their respective 200-day ma’s tends to fall off a bit. And then, when a meaningful corrective phase ultimately comes along, the number of stocks above their all-important 200-day ma’s falls even farther.
History shows that from there, most bull markets tend to resume their run for the roses. The strong bull runs manage to move past the previous high water marks and usually go on to make new highs or even a series of new highs. From a technical standpoint, this “rally resumption” phase shows up on the charts as more and more stocks reclaim their 200-day moving averages.
Our Bull Market Continuation Signal
Which brings me to our “Bull Market Continuation” indicator. But first, I must give credit where credit is due. The concept of the timing signal I am about to discuss was pioneered by the good folks at Ned Davis Research, who do tremendous work on just about anything one could imagine.
The way the signal works is as follows. When the percentage of stocks above their 200-day moving averages moves below 42% and then rises by 10 percentage points from the ultimate low, a buy signal is triggered. And from an historical perspective, these are pretty darn good buy signals.
However, we decided to focus only on the buy signals that occurred AFTER the initial bull market buy signal – I.E. the “bull market continuation” signals.
Since 1981, we have identified a total of sixteen such “continuation” signals (and for the record, we eliminated multiple signals that occurred within 2 months of the first signal). The good news is that the market tends to perform at roughly twice the average rate after a “bull market continuation” signal is given .
The Good News
One month after our “bull market continuation” signals are given; stocks have been higher 68.75% of the time (11 out of 16) since 1981. While this isn’t too bad, the average return over the next month is only about even with the return seen during all one-month periods. Thus, we can conclude that the month following our “continuation” signals can be choppy.
However, as the bull market continues, the results of the “continuation” signal improve rather dramatically. For example, two months after the signal, the market (as defined by a stock-only index, which excludes ETF’s, closed end funds, etc) has returned an average of 4.8%, which is more than double the return for all one-month periods of 2.3%. And 14 of the 16 signals have been profitable.
Looking further down the road, six months later, 81.25% of the signals have been profitable with average returns of 10.4% vs. 4.7%. And one year later, the signals proved profitable 14 out of 16 times, with average gains of +17.1% (this is far superior to the average of 9.9% for all one-year periods since 1981).
The good news is that the most recent continuation signal occurred on June 10th. So, after a period of waffling, we would expect to see the market resume its upward trend.
The Bad News (And More Good News)
Unfortunately, though, there is some bad news. On two occasions, the “continuation” signal preceded a major market top. Both the 3/16/00 signal and the 8/22/07 signals proved to be ill-timed as significant declines quickly ensued. However, the good news on the bad news front is upon closer examination of the “bad signals,” we find that there had been multiple “continuation buy” signals prior to the ones that led to the ultimate tops.
In looking at the data further, we find that since 1981, there have been a total of four “initial” continuation signals like we’re seeing now. All four proved profitable and all four occurrences sported returns that were above average across the board. Thus, we can conclude that the earlier “continuation” signals tend to be more reliable/profitable than the signals that occur later in a bull market.
In sum, we’ve got a “bull market continuation” signal on our hands, and as such, we should be looking for the rally phase to continue in the coming month or so.
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