Stock Market Sentiment: Stock Highs Vs. Lows

Includes: SPY
by: Julian Marchese

When analyzing stock indices, we have specialized knowledge that we cannot access in other financial markets. This knowledge and data is derived from all the stocks that make up a stock index! We are able to observe sector relationships (aggressive / defensive), market breadth (rising vs. falling stocks), and various other metrics that can be created and developed by anyone. One of my favorite metrics to use when analyzing stock indices is calculating all the stocks in the United States that made a one month high on a given day minus all the U.S. stocks that made one month lows on the same day. This number shows me the underlying market sentiment, and allows me to gauge if investors are buying (or selling) more stocks. In general, we want to see more stocks making one month highs than lows when the market is in an uptrend, and vice versa for the downtrend. Lets observe this sentiment indicator in action.

Notice on the chart above how as the stock market continues to one month highs, the highs-lows indicator fails to get any traction. This basically means that the stock market is moving to highs, on less stocks supporting it. This divergence is a red light for anyone buying equity into these 1 month highs.

Another way to observe this data is to create a cumulative chart of the 1 month highs-lows indicator we have developed. Instead of every day plotting a new value for the orange line, let us simply add on to the previous value and so forth. By doing this, we are able to display the direction of highs - lows.

In the chart above, our cumulative high - low indicator (red line) shows that we have been indeed moving higher (more 1 month stock highs than lows have been made on a day to day basis) since early June. The dotted black line on the chart is a 20 period moving average of the high - low indicator line. When the red line is above the moving average, it is bullish, below it is bearish. Although the line is moving in the upwards direction, it seems to me that the slope of the high - low indicator is quite moderate. If you look at previous rallies in the stock market, you'll notice that the indicator rises at a faster pace than it has been recently. This is another heads up signal for buyers of equity at these prices.

Bottom Line

Stocks that make up our stock market indices are showing less and less participation on this recent leg into new highs. One of two things must occur to resolve this situation. Either we see more stocks make 1 month highs, or the stock market pulls in. In my opinion, I am betting on the latter. I expect the stock market to sell-off to resolve this issue. I have done so by shorting a small amount of (SPY), and by buying puts on it as well. If you are bullish on equity and are looking to purchase, this simply tells you that better prices to do so may be on the horizon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am currently slightly short equity through SPY, however my positions change frequently.