Understanding how a buy or sell signal for a single stock is recorded

In PnF charting, columns of X’s are rising prices for a stock, while columns of O’s are falling prices. When a stock makes a higher high, it moves to a buy signal in PnF charting. It will not move to a sell signal until it makes a lower low. Figure 15-1 shows where new buy signals were initiated as the column of X’s made a higher high after a sell signal had been recorded. In the bottom left, there was a buy signal, and the market continued to make higher highs and higher lows until the third column of O’s made a lower low. When the chart is on a buy signal and a column of O’s goes lower than the previous column of O’s, a new sell signal is generated.

The good thing about bullish percent indexes is that they allow the market to move with pullbacks in price. They don’t switch quickly between buy and sell signals. Looking in the top right corner, the most recent signal is a buy signal as the price touched $56. Now, until the price falls to $50, which would make a lower column of O’s, the stock is on a buy signal. Therefore, Figure 15-1 currently has a $6 range between signals.

Interpreting the results for groups of stocks

The PnF chart shown in Figure 15-1 shows how one company PnF chart makes a new buy or sell signal. However, bullish percent indexes are about groups of charts. For the NASDAQ 100, for example, the bullish percent index keeps track of how many stocks are on a buy signal out of 100 stocks. When 73 percent of the stocks are on a buy signal, 27 percent are on a sell signal. Eventually, the percentage of stocks making higher highs slows, and more stocks start making lower lows. When this change occurs, you can monitor it with bullish percent indexes.

No exact percentage of breadth (stocks moving higher in the rally) is the right level to start a market correction. Every market top is different. Just using basic math, you do have an idea of when these markets start becoming sensitive to bigger pullbacks. If 75 percent of the stocks are on buy signals, for example, the market is pushing higher as three-fourths are going up and one-fourth are not. If 65 percent are pushing higher, it is still possible to make higher highs, but 35 percent are on sell signals, pulling the market average down. The bullish momentum is clearly less but still positive. If it flips so only 40 percent are on a buy signal, the market will be in a correction of some sort as the majority of stocks are going down. The bullish percent index charts give you the opportunity to try to find the sensitive levels.

Figure 15-2 shows an analysis of a one-year period of the bullish percent index (BPI) for the S&P 500 large-cap index ($BPSPX). Notice that the BPI is around 67 percent for the 500 largest companies. Remember that the $SPX is the largest broad group of huge companies in the world. This is an aircraft carrier in comparative size to other indexes, and it turns around slowly. At 66 percent, you can see the market was in a small correction in October 2016. The bullish percent index dropped quickly after it went below 61 percent.

Analyzing a three-year period with the daily chart in Figure 15-3, the $SPX looks very strong above 70 percent. A line at that level shows a strong market. You want to stay invested. The lower line is the level in mid-August 2017. When the breadth for the $SPX drops below 65 percent, the correction is larger. Two other useful points to note are that 50 percent held quite a few of the little lows and deep corrections were in the 25 percent range. Even in the huge bear markets, not all charts were on sell signals.

The final chart for the $BPSPX in Figure 15-4 expands the chart out to 20 years. The levels first shown in Figure 15-2 seem to work very well over the 20-year horizon as well. Notice that during the big downturns, the market never got back above 70 percent on the bounces. During the roaring 1999–2000 period, the $BPSPX was very low, but the market was still able to push to higher highs. Big names like Microsoft were involved in the rally, and there were lots of concerns about computers failing because of the century change. While the market went higher, only a few stocks pulled it up with only 40 percent to 60 percent of the stocks on a buy signal. Rare conditions indeed.

Looking at the basic chart

Much like the bullish percent index covered earlier in this chapter, this indicator never gets to 100 percent of the stocks. However, unlike the bullish percent index, which has lots of room between a buy signal and a sell signal, the 200 DMA is a single line. If it crosses down below one day and turns around the next day and starts to go higher, it can flip immediately. The bullish percent index has to go all the way past the previous high on the last column of X’s to change from a sell signal to a buy signal.

Figure 15-5 shows the percentage of stocks above the 200 DMA as a histogram chart. You can see big, wide black areas where breadth was plentiful and the market roared forward. There is only one line on this chart as the current level is within 2 percent of the 70 percent line. When the market pulls back early in the uptrend, most of the stocks don’t pull down to their 200 DMA, so this black histogram stays nice and high.

The histograms start to diminish in height as the rally goes on, having fewer stocks above the 200 DMA. When only 70 percent of the stocks on the $SPX are above the 200 DMA, this can be a meaningful inflection level. With the chart sitting at 68 percent, any further weakness should be evaluated as potentially more than just a pullback after a few down days.

Comparing breadth information

A long-term comparison is helpful for perspective. Once the market gets weak, looking for typical levels when investors start to hit the buy button becomes important.

In Figure 15-6, three different styles are used on the same chart. The S&P 500 index ($SPX) has an area chart, the bullish percent index for the S&P 500 ($BPSPX) has a line chart, and the percentage of stocks above the 200 DMA ($SPXA200R) has a histogram plot.

One of the advantages to plotting three different styles on one chart is the instant awareness of what each chart represents. If they are all the same, you need to keep referring to the legend. The second major advantage to plotting the information on the same chart is to look for correlation, which is normal, or one of the indicators showing a dramatic discrepancy.

Using this chart as a template for breadth makes it easy to set up multiple copies of the chart. Because the $SPX is typically the last index to break down, it is important to watch breadth on different indexes.

The NASDAQ composite breadth

The NASDAQ composite ($COMPQ) is the name for all of the NASDAQ listed stocks compiled together. The NASDAQ Stock Exchange has a lot of small tech companies that struggle as well as some exceptionally huge, successful tech companies. The index behaves different from the S&P 500 ($SPX) and can be helpful in monitoring breadth as an early warning. The threshold levels never get as strong, and the charts can show weakness early.

Figure 15-7 shows the NASDAQ composite ($COMPQ) with a bullish percent index ($BPCOMPQ) below the level the market usually breaks down from (60 percent). It also shows that the percentage of NASDAQ stocks above the 200 DMA ($NAA200R) is only at 50 percent. It will be difficult to make higher highs if only 50 percent of the stocks are above the 200 DMA.

The settings on the chart to make the display can be confusing at first. Figure 15-8 shows the settings used to create the NASDAQ composite chart shown in Figure 15-7. The chart style for the percentage of stocks above the 200 DMA is a histogram type. Use the overlay tool to add reference lines on the chart.

The NASDAQ 100 Index ($NDX) is typically the fastest-moving index because of the high-growth-rate companies that are listed there. The NASDAQ 100 list includes all the giant tech companies. Because of the size of these large companies, as long as this index continues to do well, the NASDAQ 100 market can continue to outperform. Almost all of these companies are also in the S&P 500. When the NASDAQ 100 chart holds up, usually that is supportive of the S&P 500. If the NASDAQ 100 breadth starts to weaken, that can be a much better clue that the overall market is probably going to pull back deeper than most people expect when the correction starts.

Figure 15-9 shows that the bullish percent index is very weak, with only 52 percent of the stocks on a buy signal, but the percentage of stocks above the 200 DMA shows 69 percent, well above 65 percent.

Which chart is right? If the percentage of stocks above the 200 DMA is still holding up well, the market will probably try to rally before a more serious break. If a lot of stocks are well above the 200 DMA, a significant move will be required to get below the 200 DMA.

Lastly, while it looks like the crash of the tech stocks in 2000 was obvious in the top panel, the bullish percent index was whipping wildly in extremes for multiple years. These huge percentage swings made it difficult to be on either side of the market. Unfortunately, the data for the percentage of stocks above the 200 DMA was not calculated at the time.

The New York Stock Exchange composite breadth

While the NASDAQ Stock Exchange has more high fliers (see the previous section), the NYSE has a lot of the great stable U.S. companies that investors can trust to deliver dividends and growth of capital. With so many banks, utilities, and pipeline companies listed on the exchange, the breadth charts are different as well.

A significant majority of financial, insurance, and real estate stocks are listed on the NYSE. These stocks don’t have a growth rate that compares to the NASDAQ 100, but the shareholders of these stocks are focused on dividends and consistent growth. This type of investor is a longer-term investor and does not typically chase momentum stocks.

Figure 15-10 shows both indicators for the New York Stock Exchange composite right at the levels where it usually holds. The levels are so close, there was not room to post the lines with the market levels.

The Toronto Stock Exchange breadth

Canada exports a lot of products to the United States, but its stock markets can be very different. The chart shape in August 2017 (see Figure 15-11) makes the Canadian market breadth an interesting contrast to U.S. market breadth to see how the charts break down. The BPI is well below the 70 percent level, and the percentage of stocks above the 200 DMA is below 46. The market has moved 1,000 points away from the high while the U.S. markets hit all-time highs. Using the breadth indicators would help Canadian investors see the weakness in their market before their trading account becomes damaged, while U.S. stocks continued higher almost every week.

The Canadian market has a significant weighting in oil and gas, financials, and mining. These three groups make up two-thirds of the market in Canada. While the developments in other sectors of the market can add thrust, at least two of the major sectors have to be doing well for the market to go higher.