Buyer Beware: Indicator Shows Market in 'Stealth' Correction

Tom Vician CMT's picture

Wednesday, August 19, 2015 - 12:30pm

by Tom Vician CMT

Look solely at the major indices, nothing seems amiss. The S&P 500, Nasdaq Composite and Wilshire 5000 Total Market Index are off only 2% to 3% from their 52-week highs. But despite the relative calm on the surface, hundreds of stocks are quietly tanking.

A classic technical indicator has confirmed my belief that the market is actually experiencing a "stealth" correction. 

Simply put, one of the most bullish things a stock can do is go up in price. Conversely, one of the most bearish things a stock can do is fall in price. New 52-week highs and lows show these bullish and bearish trends in action. This carries important weight as a longer-term indicator, which are slower to change but carry more significance when they do.

As a market technician, I like to keep an eye on the number of stocks making new 52-week highs and lows.

This number is extremely important when it comes to determining the strength of a market's trend. Bull markets are much stronger when paired with a large number of stocks hitting new 52-week highs. Technicians love to see this as the show of strength indicates broad leadership and support. 

Contrast this with a market that rises on a contracting number of stocks making new highs. Fewer stocks validating the overall uptrend means a tired and potentially vulnerable market. 

Now, let me show you the stealth correction in action with the following three-year chart:

Wilshire 5000

The top section of the chart above shows the Wilshire 5000, the broadest, liquid measure of the U.S. stock market. The middle panel shows the numbers of stocks making new 52-week highs (green) versus the number making new 52-week lows (red). You can see new lows really expand when the market falls. Finally, the bottom panel shows a 10-day moving average of the number of new highs minus new lows. When the average is above zero, new highs are outpacing new lows; when it's below zero, new lows are outstripping new highs.

During corrections and bear markets, we usually see the number of new 52-week lows explode dramatically.

Here's the same chart, this time with four important sell-offs highlighted. Note the surge in new lows that accompanied the declines. It's similar to what we've seen over the past few weeks.

Wilshire 5000

But there is a clear difference. Note the current paltry level of decline in the Wilshire 5000. Despite a surge in the number of stocks trending lower, the index barely budged.

Compare this to prior declines in the Wilshire 5000, which were significantly larger. This is why I call what we're currently experiencing a "stealth" correction.

You can really see this in the bottom panel with the 10-day moving average of new highs versus new lows. This is a running tab of the net change, and it's currently lower than all but one other period of decline in the market.

As a result, there have been slim pickings for new recommendations that meet the stringent criteria for inclusion in my Alpha Trader service. But wait…

Before you stop reading, please allow me to explain why this is actually a good thing -- and why it could be a good thing for your portfolio as well.

First, Alpha Trader uses a quantitative system based on two triggers. 

Respected investment firm Value Line showed that between 1965 and 2013, the first trigger returned 28,586% compared with just 1,718% for the Dow. 

This second trigger is a favorite of legendary investors like Peter Lynch, Donald Yacktman and Warren Buffett. Not only has it helped these gurus beat the market, but a 50-year back test by James O'Shaughnessy showed that stocks that met this criterion were 11% less volatile (read: risky) per year than the market.

When combined, these two triggers consistently beat the market with less risk than buy-and-hold investing. The system repeatedly flags stocks that are about to jump double and triple digits in the coming days, weeks and months.

For instance, it pegged:
 
-- Southwest Airlines (NYSE: LUV) before it rallied 54% in just over a year; 
-- Hospira (NYSE: HSP) before it made a 60% run in six months; and
-- Pharmacyclics (Nasdaq: PCYC) before it soared 55% in two and a half months.

These are just a few recent trades closed by my Alpha Trader system, but it has spotted stocks that have soared up to 242% in less than a year. But gains like this are only half of the equation. The key to any successful trading system is how it controls risk -- and the Alpha Trader system offers a unique safeguard.

When the market undergoes a stealth correction like we are experiencing now, the Alpha Trader system automatically reduces risk by purchasing fewer stocks. The system is self-modulating and unique in this respect.

Conversely, a strong and strengthening market will be filled with an increasing number of stocks making new 52-week highs, which means we'll see plenty of new "buy" candidates. Until then, we go with what the market provides.

That is the beauty of following a system like the one we use in Alpha Trader. We can trust it. While it can be difficult to sit tight, we can trust that the system will alert us when it is the right time to buy. 

If you'd like to learn more about how the system uncovers breakout candidates and be privy to its next buy signal, follow this link.

This article was originally published on ProfitableTrading.com: Buyer Beware: Indicator Shows Market in 'Stealth' Correction

Tom Vician CMT does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.