Market Indicators Elliot Wave,New Highs and New Lows, Confidence Indicator, Dow Theory

Table of Contents:-

  • Market Indicators
  • Elliot Wave Theory
  • New Highs and New Lows Theory
  • Confidence Indicator Theory
  • Dow Theory

Market Indicators

The different price indicators which measure market movement are listed below:

  1. Elliot Wave Theory
  2. New Highs and New Lows
  3. Confidence Indicator
  4. Dow Theory

The different price indicators which measure market movement are explained in detail below:

Dow Theory

The Dow Theory is one of the most popular and oldest technical tools in the finance field. Charles Dow, the founder of the Dow Jones company and the Wall Street Journal editor, developed it.

W.P. Hamilton and Robert Rhea developed the Dow Theory from editorials Dow wrote during 1900-1902. Over the years, numerous writers have modified, expanded, and occasionally condensed the original Dow Theory. It serves as the foundation for many other techniques used by technical analysts.

Charles Dow formulated a hypothesis suggesting that the stock market does not operate randomly but is influenced by three distinct cyclical trends that guide its direction. According to Dow’s theory, the market exhibits movements that co-occur. These movements are:

1) Primary Movement: This long-range cycle propels the entire market either upward or downward. It represents the prevailing long-term trend in the market.

2) Secondary Reactions: These reactions act as a restraining force on the primary movement. They occur in the opposite direction of the primary movement and last only briefly. They are also known as corrections. For example, when the market experiences a continuous upward trend, short-duration downward movements can temporarily interrupt this upward movement. These are the secondary reactions.

3) Minor Movements: These are the day-to-day fluctuations in the market. The minor movements lack significance and have no analytical value due to their short duration.

The three movements of the market have been compared to the tides, the cresting and crashing of waves, and gentle ripples on the ocean’s surface.

According to Dow’s theory, the price movements in the market can be identified using a line chart. This chart displays the closing prices of shares or the closing values of the market index may be plotted against the corresponding trading days. This chart would help identify the primary and secondary movements.

The figure below shows a line chart of the closing values of the market index:

The market’s primary trend is upward, but occasional secondary reactions move in the opposite direction. Among the three movements in the market, the primary movement is considered the most important. The primary trend is said to have three phases, each of which would be interrupted by a countermove to a secondary reaction, which would retrace about 33-66 per cent of the earlier rise or fall.

Criticisms of Dow Theory

Several criticisms are levelled against the Dow Theory

1) It is not a theory but rather an interpretation of known data. A theory should be able to explain the occurrence of a phenomenon. Dow or his followers did not attempt to explain why the two averages could predict future stock prices.

2) The forecast is not acceptable. There was a considerable gap between Trump’s actual points and those indicated by the forecast.

3) It needs better predictive power. According to Rosenberg, the Dow Theory could not forecast the bull market that preceded the 1929 crash. It gave bearish indications in early 1926. He witnessed a bull market in the 314 years that followed the forecast. Dow objectively studied Hamilton’s editorials for the 26 years from 1904 to 1929. Of the 90 recommendations Hamilton made for a change in attitude towards the market, 55% were bullish, 16% were bearish, and 29% were doubtful, with 45 being correct. An investor may achieve a similar outcome by flipping a coin.

Elliot Wave Theory

According to this theory, the market unfolds through the basic rhythm or pattern of 5 waves up and three waves down to form a complete cycle of 8 waves. This wave principle is derived from empirically tested rules studied in stock market price trends. The basic pattern of waves is reflected in various cycles and waves. One complete cycle consists of waves of two distinct phases – bullish and bearish.

Wave Personalities

Wave personalities is another area where the two theories overlap is describing the three phases of a bull market. Knowledge of different types of wave personalities can be helpful, especially when wave counts are unclear. It’s also important to remember that these wave personalities remain constant in all the different degrees of trend.

Wave 1: About half of the first waves are part of the basing process and often appear to be nothing more than a rebound from very depressed levels. The first waves are usually the shortest of the five waves. The initial waves can sometimes be dynamic, mainly when they originate from major base formations.

Wave 2: Second waves usually retrace or give back all or most of wave 1. However, the ability of wave 2 to hold above the bottom of wave 1 produces many of the traditional chart patterns, such as double or triple bottoms and inverse head and shoulders bottoms.

Wave 3: The third wave is usually the longest and the most dynamic, especially within the common stock area. The peak of Wave 1 signals various traditional breakout and Dow Theory buy signals. Virtually all technical trend-following systems have jumped on the bull bandwagon. Volume is usually the heaviest during this wave, and gaps prevail. Not surprisingly, the third wave is also the most likely to extend. In a five-wave advance, wave three can never be the shortest. By this time, even the fundamentals are showing positive signs of improvement.

Wave 4: The fourth wave usually exhibits a complex pattern. Like Wave 2, it is a corrective or consolidation phase but usually differs from Wave 2’s construction. Triangles typically occur in the fourth wave. One fundamental principle of Elliott Wave analysis is that the bottom of Wave 4 should never overlap the high point of Wave 1.

Wave 5: In stocks, wave 5 is usually less dynamic than wave 3. In commodities, wave 5 is often the longest and most likely to extend further. During wave five, many confirming technical indicators, such as ‘On-Balance-Volume (OBV),’ begin to lag behind the price action. At this point, negative divergences also start to develop on various oscillators, warning of a possible market top.

Thus, wave 1 moves upwards, and wave 2 corrects wave 1. Similarly, Waves 3 and 5 are characterized by an upward impulse, corrected by waves 4 and 6, respectively. An entire sequence of waves from 1 to 5 is corrected by the sequence of bearish waves, namely A, B, and C. Thus, in a complete cycle, there are five bullish and three bearish phases.

The impulse waves move toward the primary trend, while the corrective waves, fewer in number, can reverse the previous trend. After completing an entire cycle of waves following the termination of the last wave movement, a fresh cycle begins with similar impulses arising from market trading and shifts in market sentiment, etc. Again, there will be five cycles upwards, constituting the bullish trend, and three waves downward, constituting the bearish trend.

According to the followers of Elliot Wave Theory, the accuracy and timeliness of the waves are the basis for their usefulness in identifying the buy and sell signals in the market. Research has shown that stock market prices follow cycles and waves. it is possible to use these data for predicting price change and determining optimal buy and sell signals.

Breadth of Market

Breadth-of-market indicators are used to determine the overall performance of a wide range of stocks. It is computed by comparing market advances or declines.

Methods for Measuring the Breadth of Markets

1) Plurality or Net Advances and Declines: To obtain net advances or declines, subtract the number of issues whose prices declined from those whose prices advanced each day. Obtain the cumulative index by adding daily net advances and declines.

  • When the index is positive, the market is bullish.
  • When the index is negative, the market is bearish.

2) Advance-Decline Ratio: A simple variant of the above method is computing a ratio:

Advance – Decline ratio = Number of advances/The number of declines

  1. When the ratio is > 1, the market is bullish
  2. When the ratio is < 1, the market is bearish

3) Market Breadth Indes: This is another way of computing the advances and declines.

Market Breadth Index = 2 (advances – declines) / unchanged

New Highs and New Lows

A supplementary measure to market breadth indices is the high-low difference or index. The assumption underlying it is that a rising market will have more stocks attaining new highs and a dwindling number of new lows. The reverse holds for a declining market.

The index is computed as follows:

  1. Obtain the difference between the number of stocks making new highs and those making new lows for a year.
  2. Calculate a moving average over five days.

Such a high-low index would generally move with the market. Any divergence from the market trend is a clue to future price movements.

Market Sentiment Indicators

Sentiment indicators attempt to assess the collective sentiment of the market. In general, when a sentiment indicator shows high levels of optimism, investors are advised to exercise a higher degree of caution when approaching the market. This indicator focuses on sentiment among investors rather than on fundamental factors.

A contrarian investor uses these indicators to assess investors’ price expectations. If the majority strongly believes prices will rise, contrarian investors will sell, anticipating that most people will be wrong. Optimists are potential sellers who lean towards selling, while pessimists are potential buyers who are more likely to buy. Therefore, sentiment indicators can signal significant turning points in the market. Traders who rely on sentiment indicators feel that the higher the level of anxiety in the market, the closer the market is to the bottom.

There are mainly two types of sentiment indicators:

1) Put/Call Ratio: The put/call ratio is a standard sentiment indicator. A put option grants the purchaser the right, but not the obligation, to sell a security at a predetermined price within a specific time. A call option gives the buyer the right, but not the obligation, to buy a security for a specific price by a particular time. An extremely high put/call ratio indicates fear in the market, as significantly more investors are betting on a downturn rather than an upturn. A meagre put/call ratio suggests high optimism among investors as they actively place bets on future stock market gains.

2) Volatility Index (VIX): The Volatility Index (VIX) is another sentiment indicator. A high VIX reading indicates high volatility and tends to occur in the market during periods of fear among investors. Conversely, a low VIX reading suggests a sense of complacency, which is typically associated with stock market peaks.

Confidence Indicator (Disparity Index)

A confidence indicator should inform a technician of investors’ willingness to assume risk. One such confidence index is the Baron’s Confidence Index (BCI), which represents the ratio of the average yield of the ten highest-grade bonds to the average yield of the Dow Jones 40 bond index. In equation form, the BCI is expressed as:

BCI = Average Yield of Baron’s 10 highest grade bonds at time t / Average Yield of Draw Jones, 40 bonds at time t(lesser grade)

As bond investors become more optimistic about the national economy, they become less risk-averse, and some will shift their bond holdings to lower-grade bonds. This action will bid up prices and lower the yield on low-grade bonds relative to high-grade bonds, thereby increasing the confidence index. The BCI should always be less than one since high-grade bonds should always yield less than low-grade bonds. Some technicians believe that the confidence index is a leading indicator of the national economy, leading it by 2 to 11 months.

There are two popular indices of share prices in the USA. They are.

1) Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 Stocks Index(S&P)

Disparity Index is computed as follows:

Disparity Index = 10 (S&P – DJIA)

When the DJIA moves up faster, the market is bearish.

When the S&P moves up faster, the market is bullish.

Since the S&P index is broad-based, it better indicates the broad market movement.

Most Active List

The most active stocks in any market, showing a net gain or net loss each week, do not exceed twenty. These issues, taken as a whole, represent only 1 percent of the total issues traded but account for almost 15 percent of the total volume. Since random variations often occur in the stock market, an additional time dimension of several weeks is essential. A 3-week activity will smooth an otherwise erratic curve. Then, the upper and lower limits of the most active list become +60 and -60.

  • Bear Market Indicator: A reading of -50 follows a long and continuous decline in the market.

  • Bull Market Indicator: A reading of +35 occurs in a rising market.

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