when looking at trends in the index market.
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SIMPLE VOLUME SYSTEMIn order to confirm that increasing volume is a bullish sign for anexchange-traded fund, we created a simple system for the QQQQ. The hypothesis is that increasing volume is a bullish sign and will lead to shortterm strength in the fund. We ran a test on the Qs using five years of datafrom November 1999 to November 2004. This included both bullish andbearish periods for the fund.The system is long only and looks to enter the QQQQ when it hasmoved higher in price and volume has been rising for two consecutivedays—in other words, the volume is greater than yesterday, and yesterday’s volume is higher than the day before. In addition, the close of thecurrent day is greater than the close of the day before. We exit the tradewhen either (1) the QQQQ has moved 3.5 percent higher or (2) the QQQQrises on falling volume. If the QQQQ moves higher but volume has declined for two consecutive days, the position is closed.Table 10.2 shows the results of the volume system during the fiveyear backtest. We assume that the trader takes a $5,000 long position inthe QQQQ upon each buy signal. The system works relatively well. Thetotal profit is approximately $3,000 (excluding commissions and fees).Out of 112 trades taken, 77 were winners and 42 were losers. So for every11 winners the system produces 6 losers. While this result is very promising, the average loss is greater than the average win. Such a result is expected since the maximum gain is capped at 3.5 percent, while losses areallowed to run.In sum, this system generates many short-term profits, with largerlosses. However, the winners outnumber the losers by a sufficient marginto generate profits over the long term. To improve the system, the strategist might consider using stop-losses or an exit strategy based on a specific number of days (i.e., exit the trade after five days) after taking a moredetailed look at the trade results. Either way, the system does seem toconfirm that increasing volume along with improving price action is bullish for the Qs.In addition, this simple volume system illustrates how basic technical analysis can be incorporated into a trading plan. While volumeis used in this example, the same analysis can be done with a varietyof indicators (as demonstrated in Chapter 9 with the Volex system andthe ROC-ADX examples). The volume system also illustrates that atrading system need not be complex; it can be relatively simple. Thekey to long-term profitability, however, is not just identifying your entrypoint, but also identifying an exit strategy and a plan to manage yourlosses.
Statistic
All Trades
1999
2000
2001
2002
2003
2004
212.52
Total Proﬁt
2989.06
252.19
2152.69
146.81
(640.03)
864.89
Gross Proﬁt
10,947.42
252.19
3344.33
2904.82
1442.35
2092.18
911.43
Gross Loss
–7958.36
0.00
–1191.75
–2758.01
–2082.38
–1227.29
–698.91
Total TradesAverage Trade ProﬁtWinning Trades
3
24
27
20
25
20
84.06
89.70
5.44
(–32.00)
34.60
10.63
77
3
20
16
12
14
12
4
11
8
11
8
100.00
83.33
59.26
60.00
56.00
60.00
Losing Trades %
35.29
0.00
16.67
40.74
40.00
44.00
40.00
Open Trades %
0.00
0.00
0.00
0.00
0.00
0.00
0:00
Win/Loss Ratio
11:6
n/a
5:1
16:11
3:2
14:11
3:2
Average Winning Trade
142.17
84.02
167.22
181.55
120.20
149.44
75.95
Average Losing Trade
–189.48
0.00
–297.94
–250.73
–260.30
–111.57
–87.36
Largest Winning Trade
423.75
136.88
423.75
278.34
295.67
185.44
184.31
Largest Losing Trade
–889.31
0.00
–889.31
–646.14
–504.00
–286.11
–267.41
12
0
12
5
3
5
4
Most Consecutive WinnersMost Consecutive Losers
3
0
1
3
3
3
3
Average Time in Winners
4.57
4.33
3.70
1.88
5.17
4.64
9.00
Average Time in Losers
8.52
0.00
15.00
7.00
10.38
7.45
7.00
First Active Date
12/10/99
12/10/99
1/4/00
1/4/01
1/3/02
1/3/03
1/8/2004
Last Active Date
11/18/04
12/22/99
12/22/00
12/6/01
11/22/02
12/19/03
11/18/04
1805
12
353
336
323
350
315
Period of Activity (days)
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0
64.71
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Winning Trades %
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Losing Trades
11925.12
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TABLE 10.2 Basic Volume System Results
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MARKET INTERNALSMarket internals refers to the technical action of the market beyond themovement of the major averages like the Dow Jones Industrial Averageand the NASDAQ Composite Index. Discretionary index traders want tounderstand what is happening beneath the surface of the major averagesin order to gauge the underlying strength of the market’s advances or declines. The ratio of up to down volume, already discussed, is part of the internal action of the market. Using that ratio, the strategist can betterunderstand the strength of the buying and selling pressure that moves themarket from one day to the next.The advance/decline ratio, the Trader’s Index ($TRIN), and the newhigh–new low (NHNL) index can also help make sense of what is happening internally within the stock market.
Painting the TapeThe term painting the tape refers to the illegal practice by a group of investors to buy or sell a security among themselves in order to make itseem as if the price is rising and volume is running heavier than usual. Ina similar manner, sometimes the major averages like the Dow movehigher as large institutions aggressively buy the shares that comprise theindex. This often occurs at the end of the quarter or the end of the year.Whether it is deliberate action or manipulation is difﬁcult to say. Nevertheless, the process can make it seem as if the market is stronger than it really is. For that reason, index traders will want to consider not just themoves in the Dow and the NASDAQ, but also market internals like marketbreadth and the new high–new low index.
Market Breadth and the A/D LineThe advance/decline line (A/D line) is a useful indicator for indextraders who want to see the big picture. The line is actually an indexthat tracks the number of advancing issues on the New York Stock Exchange (or NASDAQ) minus the number of declining issues. An advancing issue is simply a stock that has moved higher in price; a decliningissue is one that fell in price that day. Also referred to as marketbreadth, the advance/decline line can be computed through a number ofcharting programs and web sites; hence, it is not necessary to computeit manually. Nevertheless, understanding the math will help make bettersense of the indicator.
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The Advance/Decline RatioOn December 19, 2005, the Dow Jones Industrial Average fell 40 points.Meanwhile, the Wall Street Journal reported that 944 stocks advanced and2,457 declined. The advance/decline ratio was more than two to one negative (–2,457/944 = –2.60). Ratios of 2.5 or more indicate extremely positive market breadth and a bullish environment. When the ratio falls below–2.5, market conditions are weak and market internals are poor. Traderswant to consider the advance/decline ratios for both the NYSE and NASDAQ. Bullish trades should focus on the exchange where market breadthis showing the most strength or improvement.
The daily advance and decline numbers for the NYSE can be found in anumber of places, including most financial newspapers and several websites. To compute the NYSE advance/decline line, subtract the number ofdeclining stocks from the number advancing stocks on the NYSE each trading day. Ignore the unchanged stocks. The result, either positive or negative,is added to the previous day’s total to create the line. So the A/D line is actually a running total. It is a cumulative expression of market breadth.Figure 10.5 shows the NYSE advance/decline line over several yearsending in the summer of 2005. It is upward sloping and suggests that morestocks are moving higher than lower on a consistent basis. That, in turn, isan indication that market internals are healthy. In fact, during that time,the A/D line was moving to new highs, but the Dow Jones Industrial Average and the S&P 500 Index were well below their spring lows. However,later that year, both indexes moved to multiyear highs. In short, the upward slope in the A/D line in summer 2005 was a sign that market conditions remained on solid ground.Another way to use the A/D line is to confirm highs and lows in themajor averages. Technicians look for divergences between the A/D lineand the market averages as a sign that a trend is ending. For instance, ifthe Dow Jones Industrial Average sets a new high, but the A/D ratio doesnot, it is considered a bearish divergence. In this case, breadth is laggingand the trader will be on the look out for the rally to run out of steam.By contrast, if the S&P 500 Index and the industrial average fall tonew lows, but the A/D sets a shallower bottom (i.e., a higher low), it isconsidered a bullish divergence and bodes well for the market going forward. The most recent divergence occurred in October 2002. At that time,the Dow Jones Industrial Average fell to multiyear lows, but the A/D ratiowas well off of its previous lows. Therefore, it gave a bullish divergence.The A/D line suggested that stocks were not as weak as the major averages seemed to suggest.
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FIGURE 10.5 NYSE Advance/Decline Line, January 2, 2003, to July 2, 2005
The Arm’s IndexThe Trader’s Index ($TRIN) has proven itself as a reliable timing indicator.Sometimes called the Arm’s Index after its originator, Dick Arm, it measures the buying and selling pressure associated with trading on theNYSE. When selling pressure becomes intense, it can be a sign that thestock market is oversold and due to bounce higher. Conversely, when buying becomes extreme, it can be a sign that the market is getting overbought and set to head lower.TRIN combines the up to down volume statistics and the advance/decline data. Although traders can easily get a latest quote using its ticker symbol $TRIN, it can also be computed using the following four pieces of datafrom NYSE trading: up volume, down volume, advancing issues, and declining issues. The index compares the number of stocks that are increasing ordecreasing in price (i.e., advancing and declining issues) with the amount ofvolume trading in those stocks (up/down volume). The formula is:TRIN =
Volume declining ÷ Number decliningVolume advancing ÷ Number advancing
Let’s assume the following statistics represent the most recent tradingday: advancing issues 2,503; declining issues 744; up volume 1,281,000,000;
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and down volume 235,000,000. When you plug the numbers into the formula you obtain:TRIN =
235, 000 ÷ 744= 0.621, 281, 000 ÷ 2, 503
In this example, $TRIN equaled 0.62. It occurred during a stock market rally as the volume going into advancing issues rose dramatically. As aresult, the Trader’s Index recorded a relatively low reading. Large volumeinto advancing issues is a sign of intense buying demand, and the indexwill fall. Heavy volume into declining issues suggests intense selling pressure. During those times, TRIN will rise.The most common way of using the Trader’s Index is to help identifyoverbought and oversold conditions. Although the indicator is updatedthroughout the day, the closing value (or the last reading of the day) generally gets the most attention. Low TRIN readings, like the one in this example, are a sign of aggressive buying into advancing stocks near theclose of the day. It is a sign that investors are extremely bullish and arepouring money into stocks like there was no tomorrow. This type of buying cannot be sustained. Therefore, closing TRIN values of 0.60 or less areindicative of short-term overbought conditions. Stocks are likely to openlower the next day.In contrast, high readings are a sign of intense selling pressure andgenerally occur before a market bounce. Readings of 2.25 or more oftensuggest that the market is oversold. When $TRIN closes above 2.25, it is agood bet that the market will open higher the next day.In addition to looking at TRIN on a daily basis, it is useful to considerthe readings over a period of consecutive days. Some traders use the sumof the index values over a period of time. For instance, the five-day TRINis the sum of the closing values during the past five days. If this cumulative value rises to high levels (9.00 or more), it suggests that the market isseriously oversold and due to rally; low readings (4.00 or less) are a signof overbought conditions.Figure 10.6 shows the 21-day moving average (MA) of the Trader’sIndex alongside the Dow Jones Industrial Average. Traders can timepeaks and valleys in the market using the 21-day moving average. Whenit falls below 1.00, it indicates the Trader’s Index has been producing asignificant number of low readings and the market is overbought. Notice the low readings from the 21-day moving average that coincidedwith short-term tops in April, June, and September 2004. Similarly, the21-day average of the Arm’s Index will rise above 1.25 when the marketis oversold. Two examples, in January and May 2005, are highlighted inFigure 10.6.
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FIGURE 10.6 DJIA and TRIN 21-Day MA (Source: www.ProﬁtSource.com)
New High–New Low IndexAnother tool for gauging the internal strength of the market is the newhigh–new low index (NHNL). The indicator is relatively straightforward. During each trading session, a number of web sites, financial publications, and data services provide a list of stocks that are setting new52-week highs and a list of stocks setting new 52-week lows, by stockexchange.The NHNL is the difference between the number of stocks in each ofthese two categories on a daily basis. For instance, on December 19, 2005,the Wall Street Journal reported that 72 stocks set new 52-week highs and104 stocks set new 52-week lows on the New York Stock Exchange. Inthat case, the NHNL would equal –32 (72 – 104), which means there were32 more stocks setting new lows than new highs.The NYSE new high–new low index is plotted in Figure 10.7. It represents the difference between the highs and lows (highs minus lows) over aperiod of time. The same chart can also be created for NASDAQ 52-weekhighs and lows. Some technicians prefer to plot the index as a histogram.Regardless, when the graph moves below the center line (the zero line), itmeans that there are more stocks setting new 52-week lows than highs onthe NASDAQ. When the line moves into positive territory, there are morestocks setting 52-week highs than lows.When looking for market strength or weakness, we sometimes lookfor confirmation from NHNL index. If the major averages make a series of
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new highs, the NHNL index should rise along with it; a declining NHNL isa sign of underlying weakness.Some technicians also watch for divergences between the NHNL index and the S&P 500 Index. This is similar to the analysis applied to theA/D line. For instance, the Dow Jones Industrial Average was performingwell leading up to the month of March 2005. However, as we can see fromFigure 10.7, NYSE NHNL was moving lower and fell into negative territoryat that time—before the Dow started its own move lower. So the NHNL Index correctly foreshadowed a period of market weakness that lasted untillate April. It gave an early warning sign that the stock market was not asstrong as the Dow might have appeared.
Crash SignalsA few other market signals can be generated from the NYSE NHNL data.They have ominous sounding names: the Titanic Syndrome and the Hindenburg Omen. The signals provided by these indicators are triggeredprior to significant market declines.Titanic Syndrome This signal was developed more than 40 years agoand is credited to Bill Omaha. It is triggered when the Dow Jones Indus-
FIGURE 10.7 NYSE New High–New Low Index (Source: ProﬁtSource.com)
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trial Average either hits a new high for the year or rallies 400 points, butthe number of new lows on the NYSE is greater than the number of newhighs within seven days of the Dow’s high. According to the Titanic Syndrome, when the signal is triggered, the stock market will crash. It camevery close to triggering a signal in December 2005 when the Dow rose toward new highs while the number of new highs trailed new lows withinseven trading days. However, since the Dow did not officially rise to newhighs (it came within 10 points), no signal was triggered.Hindenburg Omen This somewhat complex indicator also forewarnsof market crashes. Created by Jim Miekka and popularized by KennedyGammage, this indicator triggers a signal when (1) the number of stockswith 52-week highs and 52-week lows is greater than 2.2 percent of all issues on the New York Stock Exchange, (2) the 10-week moving average ofthe NYSE Composite Index is trending higher, and (3) the McClellan Oscillator (a technical trading indicator) is in oversold territory. When all ofthis occurs, it is a sign that although the market is trending higher, there isa significant amount of uncertainty and confusion—a situation that is ripefor a market crash. However, the Hindenburg Omen was triggered in thefall of 2005 and no stock market crash followed.This last point—the fact that a Hindenburg signal was triggered in thefall of 2005—brings up an important point: There are still no guarantees inthe markets. We should, however, value tools that when combined presentus with high-probability forecast scenarios.
MARKET ANOMALIESUp to this point, the discussion in this chapter has been on technical market indicators. These indicators are based on price and volume action andcan give traders a better sense regarding the strength of the market’s recent advance or decline. In some cases, they can also warn about marketreversals or potential danger.Now we turn our attention to various market anomalies that can helptraders find those sectors of the market that offer the best trading opportunities based on fundamental factors. Rather than looking at price action, volume, or other data from the exchanges, the fundamental factorsrelate to specific attributes of the companies that constitute the market.These factors help to explain why some groups of stocks perform betterthan others. Many of these so-called market anomalies are discussed indetail in David Dreman’s book Contrarian Investment Strategies (NewYork: Simon & Schuster, 1998).
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Price to DividendIn Chapter 9, we showed how the Dogs of the Dow produced superiorreturns over time. This will come as no surprise to those who alreadyunderstand the price-to-dividend effect, which explains that stocks thatpay higher dividends tend to outperform the market over the longerterm. According to Dreman, a study including more than 25 years of datashowed stocks with the highest dividend yields outperformed the market by an average annual return of 1.2 percent. The superior gain wasdue in large part to the dividends themselves. Nevertheless, a $10,000portfolio of high dividend yield stocks held over an eight-year periodwould have gained 230 percent, compared to a 203 percent gain for theoverall market.
Low P/E EffectOne of the oldest and best documented anomalies indicates that stockswith low price-to-earnings ratios tend to outperform the market over thelong haul. A P/E ratio is computed as the stock’s current price divided bythe earnings per share during the past four quarters. According to Dreman, a 27-year study that separated 1,500 companies into quintilesshowed that stocks with the lowest price-to-earnings ratios produced anaverage annual return of 19 percent, compared to an annual average return of 15.3 percent for the stock market as a whole. The study alsoshowed that stocks with low price-to-book ratios and price-to–cash flowratios also outperformed the market over the long term.
Size EffectOne of the most important anomalies is the so-called size, or small firm,effect. According to a comprehensive research study by Rolf Banz,* theaverage return from stocks in the smallest quintile outperformed thosein the largest quintile by nearly 20 percent. The study involved all of theNYSE stocks for data from 1963 to 1979. Although the study was donemore than 20 years ago, the outperformance of small caps has continued. Since 1991, the Russell 2000 Small Cap Index ($RUT) is up 450 percent, compared to a 235 percent gain for the large cap S&P 500 Index($SPX).
*Rolf Banz, “The Relationship between Return and Market Value of CommonStocks,” Journal of Financial Economics 9 (March 1981).
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Value Line EnigmaOne of the trading systems developed by Value Line Investment Surveyhas consistently baffled efficient market theorists. Value Line is wellknown for its quantitative analysis research, used to rank stocks based onearnings momentum, technical indicators, and risk. Several academicstudies have analyzed the returns and the result has been a convincingcase against the efficient market theory. For example, Fischer Black released a study* that showed Value Line’s top-ranked stocks produced arisk-adjusted return of 10 percent, compared to a –10 percent return forstocks ranked 5, the lowest ranking. The superior returns produced by theranking system have been dubbed the Value Line enigma.If various market anomalies do exist, how do traders profit from thisinformation? After all, indexes or ETFs like the SPDRs, the QQQQ, or various sector funds do not distinguish between stocks that have high or lowP/E ratios. There is no index that trades only stocks with low price-tosales or price-to-book ratios.The first consideration when looking at various market anomalies isto determine what stocks are included within a potential trading systemor plan. If you are building a universe of stocks, what kind of characteristics do these stocks share? Are they selected at random? Could results ofa volume system be improved by using only stocks with low P/E ratios?Could results be improved by screening out stocks that might benefit froma specific anomaly such as price-to-sales ratios or the size effect? In short,some strategists look to combine fundamental and technical factors whendeveloping systems or other trading plans. This is all part of the testingneeded in system development, as discussed in Chapter 9.A second way to potentially profit from various market anomalies iswith a set of relatively new exchange-traded funds that attempt to beat themarket. The PowerShares family of ETFs includes a list of funds createdaround specific “style” boxes that are designed to beat the market overtime. To be specific, the PowerShares ETFs hold the same stocks as theIntellidex indexes, which are based on proprietary strategies developedjointly by PowerShares and the AMEX. The Intellidex indexes are structured to capitalize from certain style-based investment strategies such asearnings momentum and market value.For instance, the PowerShares Dynamic Small Cap Growth Portfolio(PWT) includes 100 small cap growth stocks from a universe of the 2000small cap stocks trading on the AMEX, NYSE, or NASDAQ. Meanwhile,
*Fischer Black, “Yes, Virginia, There Is Hope: Test of the Value Line Ranking System,” Graduate School of Business, University of Chicago, 1971.
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TABLE 10.3 PowerShares ETFsPowerShares Funds
Ticker
PowerShares Dynamic Large Cap Growth Portfolio
(PWB)
PowerShares Dynamic Large Cap Value Portfolio
(PWV)
PowerShares Dynamic Mid Cap Growth Portfolio
(PWJ)
PowerShares Dynamic Mid Cap Value Portfolio
(PWP)
PowerShares Dynamic Small Cap Growth Portfolio
(PWT)
PowerShares Dynamic Small Cap Value Portfolio
(PWY)
PowerShares Dividend Achievers Fund
(PFM)
PowerShares High Growth Rate Dividend Achievers
(PHJ)
PowerShares High Yield Dividend Achievers
(PID)
PowerShares Zacks Micro Cap Portfolio
(PZI)
the PowerShares Dynamic Small Cap Value Portfolio (PWY) uses a screento search out small cap value stocks. Table 10.3 shows some of the otherPowerShares funds that have been recently launched.In December 2005, the exchange launched trading on the Value LineTimeliness Select Portfolio (PIV). It is an example of a fund designed tobeat the market rather than match a market average or index (active versus passive investing). The fund includes 50 stocks chosen based on ValueLine’s proprietary investment methodology. The Value Line Timeliness Select Portfolio holds stocks based on the Value Line ranking system discussed with respect to the Value Line enigma.It is important to note, however, that the PowerShares are relativelynew and do not see much volume; they lack liquidity (see Chapter 16 for adiscussion about the importance of liquidity). We would like to see thesefunds develop a longer history and a better following before using them aspart of a regular trading program or system. Nevertheless, for long-terminvestors seeking to outperform the market with a purchase of ETFshares, the Powershares might be worth a closer look. The details can befound at the AMEX web site (www.amex.com).
SENTIMENT INDICATORSThe stock market is a fascinating place. It is particularly interesting in thatthe day-to-day fluctuations reflect the views, expectations, and forecastsof investors around the world. Indeed, it is an arena in which the final out-
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come depends not on one individual decision maker but on the activity ofmillions of investors. Given that market moves are due to decisions of amass of market participants, or “the crowd,” and not one individual decision maker, history is replete with episodes of crowd or mob behavior. Basically, under certain decision-making situations, the individual who maynormally act quite rationally will, as part of a crowd, act based on feelingsand emotion. In the words of Humphrey B. Neill in his book, The Art ofContrary Thinking:Because a crowd does not think, but acts on impulses, public opinions are frequently wrong. By the same token, because a crowd iscarried away by