A Long-Term Look At the Nasdaq Advance/Decline

Woodshedder is starting a new series called “Indicators and edges” in which he will be testing the effectiveness of different indicators. I’m looking forward to reading it. Last night he posted some baseline results of the general market. In doing so he noted that the percentage of up days on his list of stocks fell much below the % of up days for the major indices. In noticing this he asked if anyone had a possible explanation.

I think a long-term look at the Nasdaq Advance/Decline line could explain a lot of it. I pulled the below data from Worden Bros. TC2000.

Here we see that the Nasdaq Adv/Decl has consistently dropped over the years. While this chart only goes back to 1990, the strong negative bias exists all the way back to the inception of the Nasdaq in 1971. Even during the Nasdaq bubble days of the late 90’s the Nasdaq Advance/Decline couldn’t muster a rising slope. Worden Bros. was obviously aware of this tendency when they set their beginning value at 10,000 rather than 0.

Over the 1990 – present time period shown above the NYSE Advance/Decline line has seen a slight decline, but it doesn’t have the consistent negative bias of the Nasdaq.

This is mostly due to the fact that the Nasdaq has lower listing standards than the NYSE, so if a company is going to go broke it is more likely to do so on the Nasdaq. An issue which IPOs at $25 and heads to $0 will contribute a lot of declining votes each day along the way, and that is more likely to take place in the Nasdaq.

This was first explained to me by Tom McClellan. If you’re interested in breadth statistics, I’d highly recommend checking out some of the work of the McClellans.

You may also want to check back on Woodshedder’s studies over the next few weeks as well. I’m sure there will be some interesting results.

False Breakdown Often Leads to Move Higher

The fact that the market tried to break down from its recent range Thursday and then reversed to close at a new high could be interpreted as bullish. Below is a test that describes Thursday’s action:

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Pretty solid results across the board suggest an upside breakout appears more likely than a pullback at this point.

Quick Link To Low Vol Study

With the S&P going nowhere for the last 3 days, traders may want to review this study from July.

I don't have time for a new study right now, but will hopefully get something out later today related to trading this type of environment.

Percent of Stocks Above Their 200ma's Hitting Extreme Levels

Some extreme readings are appearing in a few Worden Bros. indicators that look at stocks relative to their 200 day moving averages. One is T2107, which simply looks at the percentage of stocks trading above their 200ma. The other is T2109, which looks at the percentage of stocks trading at least 1 standard deviation above their 200ma. Both indicators are near all time highs (dating back to 1986). In fact, the only period of time in which these indicators registered higher readings was in the beginning of 2004. Below is a chart of T2107 which illustrates this:

This demonstrates just how extreme the current move is in terms of breadth. Also interesting about the chart is that we aren’t that far removed time-wise from extremely low readings. Extreme overbought doesn’t necessarily mean a decline is about to begin. In fact the last time these levels were reached in 2004, the market continued to trudge higher for about 2 ½ months before finally beginning a meaningful correction.

Relative Equity Put/Call Reading on Friday is Lowest Ever

I’ve discussed the equity put/call ratio a few times recently. In the June 12th blog I showed how extremely low readings have often been followed by selloffs. I also did a follow up to that study in the August 14th blog. The criteria I used was a put/call ratio of more than 25% below its 200-day moving average.

The CBOE has only reported the equity put/call ratios since 10/2003. On Friday the CBOE reported the lowest relative equity put/call ever. It came in at 0.39, which is nearly 45% below its 200-day moving average. This is only the 2nd time it has closed as much as 40% below the 200. The other time was 11/15/04. The SPX dropped 0.7% the next day but that was basically the end of the selloff. A few more days of chop was followed by a further market rally.

Below I’ve listed all instances where the equity put/call came in 33% or more below its 200ma.

It will be interesting to see if the inclination to sell off following extremely low equity put/call ratios can overcome the market’s recent positive momentum.

Distribution Days Quantified

I'm out of action most of this week and unable to post much. Therefore I decided to take an excerpt from this past weekend's Subscriber Letter and post it to the blog:

One sign of a potential top that some traders monitor is distribution days. It was popularized by Investors Business Daily. The essential idea is that when the market falls on increasing volume that suggests institutions are selling stock. When clusters of distribution days occur, it is a topping signal. Below are some quotes from an IBD column published on August 4th that discusses distribution.

“What you're looking for is distribution. If one or more of the major indexes (the NYSE composite, the Nasdaq, the S&P 500 or Dow industrials) falls more than 0.2% in higher volume than in the prior session, that's a distribution day.

Distribution means the big money — mutual funds, investment banks and other institutional investors — is dumping shares. That's bad news for the little guy, because institutions make up roughly three-fourths of the market and chart its direction.

IBD studies show that when you get a series of three to five distribution days over a few weeks during an uptrend, that's a red flag.”

“Identifying distribution days is crucial: If you don't, you might have the wrong take on the market's direction. Then you'll be wrong about every move you make. That's a nice recipe for financial agony…Once distribution days pile up, it's wise to scale back your portfolio. Ease off margin, and get rid of any laggard stocks first. Raise cash and move entirely off stocks if necessary.”

So the bottom line is that if the market rallying, and you see a cluster of distribution days occur within a fairly short time period, you should begin selling stocks. The market is likely heading for a tumble. Let’s take a quantified look at it.

First, before I show test results I will say that clusters of distribution days do often occur near market tops – so they got that part right. But are they predictive of a top and should they be used for purposes of early identification?

I actually devised this test 4 years ago when I wrote an article for TradingMarkets about distribution days. To test the concept I looked for the following criteria:
1) The S&P closes above the 200-day moving average (remember – we’re looking for a top.)
2) Sometime within the last 12 days the S&P closed within 1% of its 200-day high. (Again, confirming we are near a top.)
3) Over the last 12 days there have been at least 4 distribution days.

Looking for 4 distribution days within 12 trading days was the criteria I used in the original test based on information at that time. It still seems like a good number according to the above article that suggests “a series of three to five distribution days over a few weeks during an uptrend, that's a red flag.”

So if you wanted to use this red flag as a short signal, how would you do looking out over the next 1, 2, and 3 month periods?

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Needless to say these results are horrible. It appears that following a bout of distribution is NOT a good time to be selling. What if we flip the study on its head and instead BUY after such instances when distribution day counters are unloading positions?

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Not the most explosive results I’ve ever posted in term of average trade, but a decent edge nonetheless. Wins are bigger than losses and the winning percentage is pretty good. This makes for decent looking profit factors (gross gains / gross losses = profit factor).

Is this a new phenomenon? Did distribution day counting formerly work and in recent years it has failed? That might explain why IBD has discussed it for so long. Sadly, no. Below is the equity curve for the 1st test above using a 20-day holding period.

While the results have been helped out by some horrible bear markets in the last decade, it’s never been a winning concept.

So why preach it? Well, it’s rare that you’ll get a top without a bout of distribution days. Therefore, when a top actually does occur, the service or person who talks about their importance can point to the top and say “See, the distribution days signaled it. You would’ve been fine if you’d just used this tool.”

This is somewhat similar to the perception that has been created with regards to follow through days for calling market bottoms. They occur there, but they are not predictive and are pretty much a worthless tool. For detail on follow through days, you may refer to the series I wrote last year. The primary difference here is that while follow through days are generally worthless, counting distribution days to try and identify tops is worse than that – it’s hazardous.

The bottom line reality of distribution days is that when the market endures a pullback after an extended uptrend, it’s often a buying opportunity and NOT a time to sell.

Of course there are still reasons to be cautious here, but of the things I am seeing that are of concern, distribution days are at the bottom of the list.

Since I’m out of action most of this week and I’m sure this post will be viewed as controversial in the eyes of some, I’ve decided to give away the code. Rather than debate or re-run the tests different ways (I’ve already done that myself), Tradestation users may feel free to download the code themselves from the free download page on the website. Login is required. Sign-up is free and only requires a name and email address.

Big Gaps From Congestion

In the past I've looked at gaps that occured after the marekt was already extended. This morning the market is set to open down big. It closed Friday in the middle of its recent range and was not extended. Below is one way to look at it.


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There appears to be a mild upside edge, though it's nowhere near as strong as it would be if the market were already extended downwards.