Sunday, January 13, 2008

Combo MACD: A new technical indicator

With the markets in such a sad state, I have been playing around with some numbers trying to come up with a new way to spot turns in the market. I would also like a nice way to define both bull and bear markets. In this post I will present a new technical indicator that has the same peaks and valleys as the Moving Average Convergence/Divergence (MACD) indicator, but differs from it in one important characteristic, namely, that it is independent of the stock chart being examined. This important difference makes it possible to directly compare the indicator values of a basket of stocks, instead of just looking at one at a time.

The first chart shows the chart of AAPL with my indicator (I call it Combo MACD) directly below it and the original MACD at the bottom. What I want to show is that if one compares the peaks and valleys of both indicators, one will see that they match up pretty well. The advantage of the indicator can be seen in the longer term chart of AAPL. Due to the way the Combo MACD is constructed, there is no dependence on the current price of AAPL. The Combo MACD indicator oscillates between extreme readings of +5 and -3, while the original MACD is highly dependent on the underlying price.

The independence of the Combo MACD makes it possible to scan for stocks that are acting bullish (above 2) or acting bearish (below 0).

Applying the Combo MACD to the broader markets seems to identify bull and bear markets. Look at the long term chart of the S&P 500. During the bull markets of the 90's and post 2003 the Combo MACD bounced between 0 and +5. Corrections brought the reading down to 0 for short periods of time, but the Combo MACD usually bounced right back. One can see that during the transition to the great bear market in 1999 the indicator never got much higher than a reading of +2. Finally, as the market turned down, the Combo MACD plunged down and bounced between value of -3 and 0. The pattern of the bull market then returned after 2003. Notice how the original MACD does not display this kind of range bound behavior.
Finally, since it is possible to compare the Combo MACD values of many different stocks, it should be possible to define the percentage of bullish or bearish stocks in an individual index. The chart below gives the percentage of S&P 500 stocks that are below 0 (bearish) and the percentage of stocks that are above 2 (bullish). What it shows is that we are at extreme readings that have been consistent with short term market bottoms. The Combo MACD reading of the S&P 500 itself is also showing that we should bounce back a little. Whether this is the beginning of a new bear market will rely on how far the market can bounce. If we just get back up to a Combo MACD reading of +2 and then head down again, we might be in for a long bear market instead of a short one.

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