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The Market Edge "Market Letter" combines three proprietary market-timing indexes into a computer model which attempts to forecast the intermediate term direction of the market as measured by the Dow Jones Industrial Average (DJIA). These indexes are the Cyclical Trend Index (CTI), the Momentum Index and the Sentiment Index. The collective readings from the three indexes form the Market Posture which can be either bullish, bearish or on rare occasions neutral.

The Cyclical Trend Index

The primary component of the Market Posture is the Cyclical Trend Index (CTI). The CTI is based on a technical application known as Cyclical Analysis and has a track record that dates back to 1974. Over that period, the CTI has accurately forecasted the Dow's direction with better than 80% accuracy. To view the record, click here. The following is a brief explanation of how the CTI is constructed and how it is used in formulating the Market Posture.

The underlying premise of cyclical analysis is that the market, as measured by the Dow Jones Industrial Average (DJIA), tends to move in cycles that often resemble sine waves, a basic cycle which determines much of the motion in the universe. The utilization of sine waves in market forecasting is based on studies that demonstrate that stocks, and in particular the DJIA, tend to experience price reversals at anticipated time intervals. These intervals, referred to as cycles, consist of the price movement of the DJIA from a significant low to an identifiable high, followed by a retreat to a recognizable low over a predetermined time frame. There are five identifiable cycles, each with different time durations at work in the market at all times. Cyclical analysis systematically determines the beginning and ending points of these various cycles enabling the analyst to accurately time purchases and sales for maximum profit.

To picture how these cycles influence price direction, visualize the stock market as a piece of elastic that is constantly subjected to positive or negative forces exerting pressure in either the same or opposite direction. These forces are the five cycles that are incorporated into the CTI. The cycles vary in duration with the shortest being only 6 weeks and the longest lasting 4 to 4 ½ years which coincides with a typical business cycle. The following table categorizes each cycle by the average time duration that it experiences from a significant low to either a higher low or new lower low.

A 6 weeks (+or-) 1 week
B 18 weeks (+or-) 2 weeks
C 36 weeks (+or-) 4 weeks
D 72 weeks (+or-) 7 weeks
E216 weeks (+or-) 20 weeks

Theoretically, each of the above cycles exerts upward pressure at the beginning of its time frame and continues to do so until it is one-half completed. At this point, the process is reversed resulting in negative pressures being applied to the DJIA. Life would be simple if only one of the cycles was factored into the equation. However, when dealing with five cycles, the picture can become confusing. For example, two of the cycles may be pointing up while one is flat and the remaining two are pointing down suggesting a market in flux. Maybe yes – maybe no!

In order to get a complete picture of the cyclical status of the market, the positive and negative forces need to be combined into a single indicator that has predictive value. To accomplish this goal, each of the cycles is assigned a numerical value based on the amount of time that has lapsed since its previous cyclical low. Values are positive in the early stages of the designated time frame, and begin to decline as time goes on becoming negative toward the end of the period. The shorter cycles receive higher values since they are more dominant. The total of these values is called the CTI and it is a very powerful tool in forecasting the intermediate term direction of the DJIA. CTI readings of +1 and higher indicate a bullish trend in the market, whereas a 0 to -15 value signals a downward, bearish scenario.

The chart below shows the DJIA from 2/7/03 to 02/06/04. Four of the cycles (B, C, D & E) are plotted on the chart. Cycle A is not included because of its short length (6 +or- 1 week). As can be seen from the graph, all of the cycles bottomed the week ending 3/14/03 signaling the end of the 2000 – 2003 bear market. Cycle B (18 +or- 2 weeks) bottomed on 08/15/04 and again on 11/28/04. Cycle C (36 +or- 4 weeks) bottomed in harmony with Cycle B on 11/28/04. Neither Cycle D (72 +or- 7 weeks) nor Cycle E (216 +or- 20 weeks) posted a new bottom over this period.

Resetting The Counts For The Various Cycles

There is one problem that crops up when determining the starting point for each of the cycles. The rule is that when the count for a cycle nears the end of its pre-determined time period, the DJIA must post a higher intra-week low when compared to the previous week’s low. This will cause a reset of that particular cycle’s count to week #1. The problem arises when during the week following a reset a lower intra-week low occurs which would abort the reset and can have a negative effect on the CTI.

Compounding the problem is the fact that the cycles are harmonic meaning that they exist within each other. For example, within Cycle E (216 weeks) there are three Cycle D’s (72 weeks), six Cycle C’s (36 weeks), twelve Cycle B’s (18 weeks) and thirty-six Cycle A’s (6 weeks). Cycle D encompasses two Cycle C’s, four Cycle B’s and so on. Since the CTI is the total of the various cycles’s values, an aborted reset can change the CTI. Fortunately, this only occurs once a year when Cycle A, B and C are simultaneously reset, once every 1 ½ years when Cycle A, B, C & D are reset and once every 4 to 4 /12 years when all of the cycles are reset.

Forecasting The Intermediate Term Direction Of The DJIA

The CTI is a unique market timing tool in that it is a trend forecaster, not a trend following indicator such as moving average crosses or MACD. Assuming that the projected starting points for the various counts are correct, an extended forecast can be made with a high degree of certainty. Such a forecast is made every year and is presented in the January issue of ‘On The Edge’ which is located on the Market Edge web site. The forecast projects periods of strength and weakness for the DJIA based on the projected CTI readings. The forecast is adjusted throughout the year whenever there is a change to any of the counts.

The Momentum Index

The Momentum Index is designed to measure the market's positive or negative divergence by comparing the relationship of nine broad market indexes to that of the DJIA. Measuring divergence is an important tool when attempting to project the market's future direction. In addition, the index tracks five breadth indicators which measure the broadness of market moves. Each of these indicators is assigned a +1, 0 or -1 value based on its bullish, neutral or bearish connotation. Positive numbers are the result of an index outperforming the DJIA on a percentage basis when compared to the index’s previous cyclical low or when an index declines less than the DJIA when compared to the index’s previous cyclical high (positive divergence). Negative values occur when an index underperforms the DJIA when compared to the prior lows or when an index declines more than the DJIA when compared to the prior highs (negative divergence). Readings over +3 are regarded as bullish while readings under –3 are deemed to be bearish. The Momentum Index is updated weekly and is located at the top of the Market Edge “Market Letter”.

The following is a description of the various indicators and studies included in the Momentum Index.  
Momentum Index:+7Positive

Momentum Index ComponentsCurrent ReadingPrior WeekConnotation
**Dow Jones Industrial Averages (DJIA):10543.2210592.21 
**DJ Transportation Average3686.033726.74Positive
**S&P 500 Index1188.001191.17Positive
**NYSE Composite Index7028.517092.62Positive
**NYSE Advance-Decline Line5183852772Positive
**10 Day MA Advance-Decline Line0.971.19 Negative
**AMEX Index1392.081415.58 Positive
**NASDAQ Composite Index2128.072147.96 Positive
**DJ Utilities Index319.69319.68 Positive
Trin (5 Day Average)1.190.98 Neutral
NYSE Weekly New Highs-New Lows 834-36604-23 Positive
Zweig Breadth Indicator0.550.63 Neutral
McClellan Oscillator869 Neutral
McClellan Summation Index43144807 Positive
Unchanged Issue Index0.050.04Negative
**Connotation denotes Positive or Negative Divergence from the DJIA

Divergence is a technician's term that describes whether the DJIA is performing better or worse than the majority of the other market indexes. Whenever the DJIA goes its own way or diverges from the broader market indexes for a period of time, whether up or down, a market turn is usually at hand. Bearish divergence occurs when the DJIA makes a new cyclical high and the majority of the other indexes do not. Conversely, bullish divergences occur when the DJIA makes a new cyclical low and the majority of the other indexes do not. When the DJIA makes a new high or new low and the majority of the other market indexes are doing the same, the DJIA’s move is said to be confirmed. On the other hand, a new cyclical high or low recorded by the DJIA accompanied by diverse moves by the majority of the other indexes is referred to as a non-confirmed move.

The following index’s are tracked and compared to the percentage movement of the DJIA in order to spot either positive or negative divergence.

      Dow Jones Transportation Index (DJTA)
      S&P 500 Index (SP-500)
      New York Stock Exchange Composite (NYSE)
      NYSE Advance-Decline Line (A/D)
      10 Day Moving Average of the NYSE Advance-Decline Line
      American Stock Exchange Index (AMEX)
      NASDAQ Composite Index (NASDAQ)
      Dow Jones Utilities Index (DJUI)
      NYSE Weekly New Highs-New Lows

Breadth indicators measure the broadness of a market move. A healthy market exists when more issues are advancing than declining and volume on up days exceeds the volume on down days. The following indicators are incorporated into the index to monitor these conditions.

      Trin (5 Day Moving Average Of The Arms Index)
      Zweig Breadth Indicator
      McClellan Oscillator
      McClellan Summation Index
      Unchanged Issue Index

The Momentum Index is a reliable tool in spotting significant trend reversals. The Dow Jones Industrial Average is a weighted average of thirty blue chip stocks. It is the most widely followed equity index in the world and is the standard measurement of the health of the US equities markets. Since the DJIA only contains thirty stocks, its performance can mask the underlying strength or weakness of the market as a whole.

Typically, a significant DJIA move is accompanied by a series of confirmed highs or lows which occur over an extended period of time that can last up to 3 years. During a bull phase, positive values from the Momentum Index confirm the move as long as the DJIA’s new highs are matched by the broader indexes. When the DJIA makes a new high which is not confirmed, the index will turn negative signaling a reversal of the trend. Conversely, during a bear market, negative values indicate that the DJIA is making confirmed lows. The Momentum Index will remain negative until such time that the broader indexes begin to outperform the DJIA by either moving up or declining at a slower rate. At that point, the Momentum Index will begin to generate positive values suggesting an end of the bear phase.

The Sentiment Index

The Market Edge "Sentiment Index" measures the market's bullish or bearish sentiment by following the status of eleven sentiment indicators. It is a measurement of the degree of optimism or pessimism prevalent in the market. Whenever the crowd becomes overly optimistic, a bearish condition, the readings from the Sentiment Index will drop into negative ground. Conversely, when fear is rampant, which is typically a bullish condition, the index will be in the +3 to +6 area.

Sentiment Index: -1Bearish

Sentiment Index ComponentsCurrent ReadingPrior Week Conotation
Odd Lot Short Ratio (5 Day Avg.)12.0911.74Bullish
Shares Sold Short NYSE - Monthly (000)78253837955345
NYSE Short Interest Ratio-Monthly – Oct.5.105.90Bearish
Shares Sold Short NASDAQ - Monthly (000)48819554998591
NASDAQ Short Interest Ratio-Monthly – Oct.3.183.29Bullish
Public-Specialist Short Ratio1.631.64Bullish
Put/Call Ratio (5 Day Avg.-Index Options)1.471.67Neutral
Dividend Yield Spread3.623.42Bullish
Mutual Fund Liquid Asset Ratio-Monthly – Oct.4.44.3Bearish
Bullish Investment Advisors60.857.3 Bearish
Bearish Investment Advisors21.722.9Neutral
Bearish + Corrections Total39.243.7Neutral
VIX (CBOE Volatility Index)12.8813.91Bearish

Bull markets climb a wall of worry. They get their start after the market has been in a long down turn. Typically, economic conditions are horrible and the public could care less about the stock market. Conversely, bear markets usually start when things look great. The market has been in an extended up trend, economic conditions are strong and the public can't get enough of Wall Street.

Determining when these conditions exist can be as simple as following the media. However, a more reliable approach is to track the status of several sentiment indicators which when viewed collectively are a good indication of when the market's sentiment is reaching either bullish or bearish extremes. Never hang your hat on a single indicator since they don’t always work alone. However, good results can be obtained when the majority of the indicators are pointed in the same direction. The following sentiment indicators, which are included in the Sentiment Index, have a proven history of accurately reflecting the market's mood and can be valuable tools in forecasting when a significant turn in the market is likely.

Odd Lot Short Ratio (5 Day Avg.): The number of Odd Lot shares sold short divided by the total number of Odd Lot sales. The higher the ratio, the more bullish the indicator since this unsophisticated group of traders are seldom right when shorting stocks. Readings of 0 to 5 are regarded as bearish, 5.1 to 9.9 are neutral while 10 and higher are bullish.

NYSE Short Interest & Ratio: The number of shares sold short on the NYSE divided by the average monthly trading volume: Values above 3.5 are bullish, 3.0 to 3.5 is Neutral and 0 to 3.0 is bearish. The NYSE short ratio is a measurement of sophisticated investors trading activities. Its importance lies in the fact that shares sold short must eventually be bought back providing potential buying power for the market. The indicator has lost some of its significance since the mid-1980's as a plethora of trading strategies have been developed that employed shorting shares as part of the approach which artificially inflates the ratio. However, it is still a good gauge of the prevailing sentiment in the market.

NASDAQ Short Interest & Ratio: The number of shares sold short on the NASDAQ divided by the average monthly trading volume: Values above 3.5 are bullish, 3.0 to 3.5 is neutral and 0 to 3.0 is bearish. Like the NYSE Short Ratio, its importance lies in the fact that shares sold short must eventually be bought back providing potential buying power for the market.

Public-Specialists Short Ratio: The number of NYSE shares sold short by the public divided by the number of shares sold short by the specialists. Readings of 1.50 or higher are bullish, 0.67 to 1.49 is neutral while 0.67 or less are bearish. NYSE specialists are the most sophisticated traders on the street. Their function is to maintain an orderly market in the stocks in which they make a market. They accomplish this by buying stocks when there is an imbalance on their books and by shorting stocks when there is a shortage of supply. When the ratio moves over 1.50, it reflects a situation whereby the public is shorting more stock than the specialist which is a bullish condition. This can be the result of either a large public short condition, which must be covered, or a small specialist short position do to a lack of buying pressure in the market. Either scenario sets up a bullish condition for the market. Conversely, when the ratio declines below 0.67 it reflects a situation whereby the public is shorting less stock than is the specialist. This can be the result of either a small public short condition, which doesn't provide any fuel to the market, or a large specialist short position due to large buying pressure in the market. Either scenario sets up a bearish condition for the market.

Put-Call Index Option Ratio: A five day moving average of the number of CBOE index put options divided by the number of index call options that have been purchased on a daily basis. Ratios greater than 1.70 are bullish, 1 to 1.69 is neutral and 0 to .99 is bearish. The Put-Call Option Ratio is an excellent measure of current bullish/bearish sentiment in the market. Whenever the crowd gets overly bullish or bearish, odds favor the market heading in the opposite direction. Note that this ratio is compiled from index puts and calls, not the equity options. Individual stocks are subject to numerous arbitrage and trading strategies that involve the use of options as a hedging mechanism and fail to provide accurate sentiment readings.

Dividend Yield Spread: The relationship between the yield (dividend rate) for the stocks in the DJIA and the yield on the highest-grade corporate bonds: Ratios between 0 and 5 are bullish, 5.1 to 6 is neutral and 6 and above is bearish. A low spread is bullish since it indicates that on average, the rate of return from dividends compares favorably to those from high-grade corporate bonds. Large differences suggest that higher yields can be gotten from bonds, a negative for stocks.

Mutual Fund Liquid Asset Ratio: The ratio of mutual fund cash to total assets. Ratios higher than 10 are bullish, 6 to 10 is neutral and 0 to 6 is bearish. With the explosion of mutual funds in the 1990's, the liquid asset ratio has become a significant sentiment indicator. When cash levels fall below 6, the public exposes the funds to potentially forced sales in the event of a rash of redemptions. Conversely, when funds have a surplus of cash, 10 and up, explosive buying potential exists.

Bullish Investment Advisors: The percentage of newsletter writers who are bullish on the prospects for the market as measured by Investors Intelligence: 0 to 40 is bullish, 40.1 to 54.9 is neutral and 55 to 99 is bearish. The majority of newsletter publishers utilize trend following methods in determining their market calls and stock selections. As a result, this indicator typically trends either up or down in step with the market. As the market moves higher, a greater number of advisors hop aboard resulting in an increase in the percentage of bullish advisors. Assuming that individuals follow these advisors recommendations, the amount of available cash that they have earmarked for stocks declines leaving less fire power to fuel the advance.

Bearish Investment Advisors: The percentage of newsletter writers who are bearish on the prospects for the market as measured by Investor's Intelligence. Readings over 50 are bullish, 21 to 49.9 is neutral and 0 to 20.9 are bearish. This indicator also trends either up or down in step with the market. As the market moves lower, a greater number of advisors throw in the towel resulting in an increase in the percentage of bearish advisors. Investor's cash reserves that are earmarked for stocks rises leaving a reservoir of potential firepower to fuel the next advance.

Bearish + Corrections Total: The percentage of newsletter writers who are either bearish or forecasting a correction for the market as measured by Investors Intelligence. Readings between 0 and 29 are bearish, 20.1 to 69 is neutral and 69.1 to 100 is bullish.

VIX (CBOE Volatility Index): VIX is a measurement of the level of implied volatility in index options. It is calculated by taking a weighted average of the implied volatility of eight OEX calls and puts with an average time to maturity of thirty-days. Low readings, between 0 to 20, signal complacency in the option pits and are bearish, 20.1 to 29 is neutral while readings over 29.1 are bullish.

Each of the indicators are assigned a +1, 0 or -1 value based on its bullish, bearish or neutral connotation. The total of these values determines the status of the Sentiment Index. Totals of +3 and higher are bullish, 0 to +2 are neutral and less than 0 are bearish.

The Strength Indexes

The DJIA seldom moves up or down in a straight line. Instead, an up or down move over a period of time is typically accompanied by periods of strength or weakness that go against the current trend. In addition, markets don't always move in tandem. While the DJIA may be in a powerful up trend the NASDAQ or the OEX may be in a consolidation phase. To address these situations, Strength Indexes, which measure accumulation and distribution for the three major indexes have been developed and are included in the Market Letter.

Strength Index - DJIA (DIA):60.052.0POSITIVE
Strength Index - NASDAQ 100 (QQQQ):41.739.7NEGATIVE
Strength Index - S&P 100 (OEX):56.755.7POSITIVE

Strength Indexes are technical indicators that signal when a counter move to the prevailing Market Posture is likely to occur. The Strength Indexes are constructed by dividing the number of stocks which are deemed to be under accumulation (bullish) by the number of stocks in the index. The result is a number that ranges between 0 and 100 which is the percentage of stocks in the index that are under accumulation. Strength Index readings over 50% are considered to be positive (bullish) while those under 50% are negative (bearish).

Accumulation is a technical term which means that over a period of time, the stock has traded more shares on up days than on down days suggesting more buyer induced transactions. The Market Edge Up/Down Volume Ratio and U/D Slope identify stocks which are under accumulation. The U/D ratio is a 50-day ratio of a stock's daily up-volume to daily down-volume. This ratio is calculated by dividing the total volume on days when a stock closed up by the total volume on days it closes down. Readings of 1.0 and greater denote accumulation (bullish), while readings under 1.0 signal distribution (bearish). The U/D Slope identifies the direction in which the Up/Down Volume Ratio is pointed. Although the raw U/D Volume Ratio is a valuable indicator, it is the direction or Slope of the ratio that forewarns of a change in the trend of the index’s price. If the ratio was at 1.5 and is now 1.2, the U/D Slope would be negative despite a bullish reading of over 1.0 since the value is on the decline.

The Strength Indexes are a powerful tool when combined with the Market Posture to determine entry and exit points into the market. When the Market Posture is bullish and the Strength Index is positive, expect favorable price action. A bullish Market Posture coupled with a negative Strength Index warns of a consolidation phase. Conversely, a bearish Market Posture and a negative Strength Index would suggest a period of declining prices while a bearish Market Posture and a positive Strength Index would imply a period of positive consolidation.