After breaking higher last Monday, the market has spent the last five days in a low-volatility consolidation. Volatility, like price, tends to be mean reverting. Therefore we may see some bigger moves as the week moves on. Potential news movers include the FOMC minutes tomorrow, Retail Sales on Wednesday, or CPI on Friday. I closed out my index short position on Friday morning for a small gain and am waiting for the market to become extended again (either up or down) before attempting another trade.

In last Monday’s column I showed a chart that displayed the relative strength of the NASDAQ vs. the NYSE Composite indices. I received a few questions on this indicator so I thought I’d revisit the chart and discuss my interpretation of it.

Below is an updated chart as of today (chart is weekly). To review, what the indicator shows is whether the NASDAQ or NYSE Composite index is leading. If the red line is above the yellow line, then the NASDAQ is leading. If the red line is below the yellow line, then the NYSE is leading. For the last couple of weeks the NASDAQ has lagged.



The indicator is formulated in the following way:

1) A ratio is taken of the NASDAQ to the NYSE. Currently that ratio is about 0.27 as shown in the chart. This ratio is plotted as the red line.

2) A simple ten-week moving average is taken of the above ratio. This is plotted as the yellow line.

I should note that the indicator is somewhat controversial. People that dismiss the usefulness of it say that the beta of the NASDAQ is higher than the beta of the S&P 500. Therefore, in up markets the NASDAQ will tend to go up more and in down markets it will tend to go down more. The lagging relative strength of the NASDAQ is the EFFECT of a down market - not the CAUSE. It's all a function of beta and therefore not particularly useful.

Proponents of the indicator claim that the types of stocks that make up the NASDAQ are more speculative in general than those that make up the NYSE Composite. Since NASDAQ stocks are more speculative, out performance of these indicate that investors are generally feeling good about market prospects. This will cause investment dollars to flow into the market and lead to a bullish environment. When investors are becoming bearish, they will seek out safety and tend to favor NYSE over NASDAQ stocks. Generally, when they are less optimistic about the market, less dollars will flow in and the market will struggle to advance and perhaps even decline.

So which came first, the chicken or the egg? Frankly, I don’t know. What I do know is that historically, the indicator has done a nice job of being on the right side of the market for major moves. You should be aware that over time this indicator has given a decent number of false signals. For instance, after last weeks column some people were wondering if the bearish move in the indicator would be a useful short trigger. Historically, I would have to say, “no”.

Since 1971, if someone shorted the market (either NYSE or NASDAQ) every time the indicator flipped and the NYSE was leading, and then covered their short when the indicator moved back to bullish, they would have lost money about 60% of the time. From a profit standpoint this strategy would have been slightly profitable for trading the NASDAQ and slightly unprofitable for trading the NYSE.

So what good is the indicator if it is prone to false signals and why would I care that it recently went negative? Because over time it has consistently been on the right side of major trends. Whether that is due to it being the chicken or the egg I don't know. I'd be very hesitant to try and trade against it for any length of time. At the same time, due to the large number of whipsaws and false signals, I believe it is better suited as a confirming indicator than as a trigger. Currently it is flashing a warning sign…

Best of luck with your trading,

Rob
Rob@HannaCapital.com

For those who may be looking to expand their knowledge beyond just market timing, my Hanna ETF Money Flow System utilizes the VIX in generating trading signals for spread trades.

Rob Hanna is the principal of a money management firm located in Massachusetts. He has spent the last several years developing and refining methods for trading in stocks across multiple time frames. He selects stocks using both fundamental and technical criteria, and then trades them using technical analysis techniques.