I learned about this indicator in an article by Mark Arbeter in the January 31 issue of the S&P Outlook entitled “Overheated Bulls? A correction could be looming for the S&P 500″. I can not reproduce the article here because of copyright issues, but be sure to read it if you have access to the S&P Outlook.
Here is the gist of the article: Arbeter presents a technical study of NASDAQ and NYSE volume trends which has a good track record for identifying intermediate-term stock market trend change points as much as a month or two before they occur. This indicator is the three week average of the ratio of NASDAQ weekly volume to New York Stock Exchange weekly volume. When NASDAQ volume rises to an extreme high in relation to NYSE volume, it shows that speculation has become excessive and a correction may be imminent. Likewise, when NASDAQ volume falls to an extreme low in relation to NYSE volume, it shows that investors have become afraid to take on risk and a rally may be at hand.
The cutoff points given for identifying extremes for the ratio are 1.40 and 1.10. Only four years of data are presented, but in studying the accompanying chart it is clear that readings below 1.10 for the ratio have coincided with excellent times to buy in 2003, 2004, 2005, and 2006. Ratio readings above 1.40 have tended to precede market peaks during the same years. The ratio identified more buying opportunities than selling opportunities during this period, but there were at least one of each per year.
Arbeter’s purpose for presenting the information at this time is that the NASDAQ/NYSE volume ratio indicator exceeded 1.40 and therefore was giving a sell signal at the end of 2006.
I am not a short term trader or a short-seller, so I plan to use this indicator to consider a contrary position when NASDAQ sentiment has become excessively bearish, and turn my attention to NASDAQ growth stocks and high-beta ETFs such as QQQQ, XLK, or FDN. Of course these stocks are normally avoided by value investors, but they do offer portfolio diversification and the potential for extraordinary gains, so it is wise to watch for them to go on sale.