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Breadth & Depth: Bullish?
Author: James Brumley (info)
Website: http://bluegrassportfolio.com
Posted: March 22nd, 2007 at 8:00 am EST
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Several days ago we discussed - in more than a little detail - the ins and outs of using the Arms Trading Index (called ‘TRIN’ for short) as a way to spot potential market reversals.
In a nutshell, the massive plunge from three weeks ago? Well, according to the ARMS Index, it was so bad, it actually had bullish implications. The TRIN reading showed the selloff was so powerful, there was really nowhere to go but up!
While we never assume anything, after yesterday, we have to wonder if the TRIN reading was accurate in its predication. Let’s dig even deeper into how TRIN works, as we may find a bigger-picture clue about what’s in store for stocks around the corner.
Basically, the Arms Index compares breadth and depth to make sure they’re proportional.
By ‘breadth’ we just mean the number of socks that are moving higher on any given day relative to the number that are moving lower. ‘Depth’ is just a reference to the degree of advancing and declining volume. In a normal environment, the ratio of advancers to decliners should roughly be the same as the ratio of ‘up’ volume to ‘down’ volume.
The index is just a simple ratio of those proportions. If everything is balanced, the result is a reading of 1.0. When the market gets out of balance though, the reading shoots well past or well under 1.0. And, a correction of the imbalance becomes more likely. This is the aspect of TRIN we’re interested in….when reversal pressure starts to kick in.
As you may realize, the day-to-day TRIN reading is a little too erratic to use as an indicator. Many short-term traders have accepted a 10 day moving average of the TRIN reading as the ‘right’ way to spot trade-worth reversal pressure.
We’ve plotted a 10 day average of the TRIN Index on the chart below in blue along with a graph of the S&P 500 Index. The actual TRIN reading is the faint grey line. Sure enough, when the 10 day average of the Arms Index gets to an ‘extreme’, reversals become likely. Those extremes are marked with dashed lines. (1.3 is oversold/bullish, and 0.85 is overbought/bearish)
The bullish scenarios are marked in green arrows, and the bearish ones are marked with red arrows. No, it’s not perfect, but still pretty darn good.
S&P 500 with 10 day average of TRIN
That, however, is the 10 day line. As you may have figured out, we’re not yet to the overbought level. So, at least as far as the short-term is concerned, there’s still some room for more upside before the breadth and depth imbalance becomes unbearable.
The thing is, it’s not just short-term traders looking at this kind of imbalance pressure. Intermediate-term traders, and even long-term investors, are thinking about the same kind of reversal clues. They’re just doing it with different lengths of the moving average.
The intermediate-term traders (the ones thinking in weeks or a few months) get some practical use from the 20 day moving average of the TRIN reading. On the chart below, we’ve changed the 10 day average of TRIN to a 21 day average of TRIN, and plotted it in purple. There are fewer signals this way, but the ones we get are pretty powerful.
S&P 500 with 21 day average of TRIN
More importantly, as you can again see, we’re still fueled by a bullish signal - the one where the 21 day average reached as high as 1.3.
Don’t worry - even the long-term investors can get in on the action worth a 55 day moving average of TRIN. In this long-term case, it’s excessively difficult for the average line to get all the way to 1.3 or 0.85. But when it does, it tends to stay well above or below those levels for weeks if not months on end. In 1999, we were technically overbought for almost a full year. In 2002, we were oversold for almost a full year. Obviously that negates the ‘reversal’ benefit of the tool. So, we take the long-term strategy with a grain of salt - in most circumstances.
To help combat the problem, we’ve opted to use Bollinger bands (blue) to spot the relative extremes for the 55 day TRIN average. It’s still not perfect, but better. We get a lot fewer signals, but the ones we got signal the biggest and most prolonged of trends. We had to put a couple of different charts in below, to show you the full spectrum. In most cases we become oversold or overbought a bit too early, but at least it will tell you when to get ready.
S&P 500 with 55 day average of TRIN & Boll. Bands - 2002
S&P 500 with 55 day average of TRIN & Boll. Bands - 2006
In any case, now you know where the market stands for the time being….some room to run in the short-term, relatively neutral in the long-term, and pretty close to being oversold in the intermediate-term.
Though it’s not an indicator we’d ‘take to the bank’, it’s at least worth keeping tabs on. However, there are conflicting signals as well….more on those in another TrendWatch. In the meantime, we’ll let you know when and if things change.
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Indexes, James Brumley, Stock Market, Trading
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