Trading the BPI Reversals
Adam Hamilton February 13, 2004 3528 Words
Regardless of how it is spun, when you cut to the chase today’s US stock markets look like an echo-bubble, a mini-mania eerily reminiscent of 1999.
Valuations today are extremely high by all historical standards and general sentiment is overwhelmingly greedy. Irrational exuberance is back with a vengeance and the ultimate price to pay this time around will be very high, just as the bust after the Great Bubble of 2000 exacted a terrible toll on all who brazenly ignored valuations.
Yet, for my fellow contrarian investors and speculators who share my strong conviction that this current echo bubble will not last, timing remains a vexing issue. Since last March, every single time that contrarians, especially speculators, tried to bet with history and against this maniacal rally, we lost. After one gets kicked in the teeth enough times in a row the wise choice is to pull back and wait, and indeed this is probably why short interest generally remains so light today.
Nevertheless, as we patiently watch and wait, ready to seize the opportunity when the bulls’ mini-mania runs its course and ultimately fails, we can study the markets and learn. Trading the sentiment indicators is probably not viable at the moment, since they have been screaming to go short continuously for almost an entire year. And if we can’t rely on sentiment indicators to anticipate a major top this particular time around, then we can use other technical tools to strive to recognize the top shortly after it occurs.
The ultimate top of this cyclical bull will be marked by falling prices. It seems elementary, but how can we decide in real-time whether falling prices are just another trivial pullback in a bullish uptrend or a precursor to a major new downtrend? One unique set of tools that may help us sort out these confusing technicals is the Bullish Percent Indices.
If you are not familiar with the Bullish Percent Indices (BPIs), I discussed them in last summer’s “Trading the NYSE BPI” essay. They are Point-and-Figure (P&F) Charting tools that tell us what percentage of stocks in a given index are currently flashing P&F buy signals. These BPIs are a contrarian tool as well, as the idea is to go long when this percentage is very low, when few P&F buy signals exist, and to throw short when this percentage is very high, when P&F buy signals abound.
For example, if 10 of the Dow 30 stocks were showing P&F buy signals on their individual price charts, the Dow 30 BPI would read 33%, which is really low. This would be the time to consider going long, buying low when the technicals are ugly and few are willing to assume any risks. Conversely, if 25 of the Dow 30 stocks had P&F buys on their charts, the Dow 30 BPI would ready 83%, on the high end. This would be the moment to consider throwing short, betting against stocks when the majority is once again convinced that they are a sure thing.
The BPIs are particularly useful because they illuminate subtle trends underneath the surface of a major index that are not readily apparent from its headline numbers. If a stock index is stalled and trading sideways, but its BPI is increasing, it can be a healthy technical sign that the rally is continuing beneath the surface and the index is due to charge even higher. But if an index is stalled and its BPI is falling, it can be an early warning sign of an impending trend change to bear mode again.
The BPIs can highlight falling prices of index components underneath the surface before the headline index number itself begins to fall in earnest, extremely valuable data to have! If a stock index’s technical foundation is crumbling, a fall in its headline number can’t be too far behind.
One BPI trading methodology, which I have been studying a lot during this current US equity rally, involves watching for what are called BPI reversals as potential trading signals. A BPI reversal occurs when a given BPI makes a new rally-to-date high, and then starts sliding backwards from this interim high.
The most common reversal number targeted is 6%, although as the graphs below show this has led to some false starts for contrarians in the past year. Nevertheless, this concept still shows much promise and will help us recognize as early as possible when this cyclical bull is finally ending.
Both the idea of and logic behind BPI reversals are simple. Since the BPIs summarize the number of stocks in a major index that have P&F buy signals on their charts at any given time, they can grant us a crucial early warning of technical weakness underneath the surface. If a BPI percentage is declining, it means more and more of an index’s component stocks are decaying into technically foreboding territory on their individual charts.
So if a given BPI for an index falls by 6% or so from its latest interim high, contrarian speculators need to take notice. The 6%+ reversal in a BPI can indicate fading internal technicals that betray a coming major trend change. Indeed, such BPI reversals will be witnessed shortly after this major equity rally that has powered higher so relentlessly for a year finally gives up its ghost.
On a practical note, watching these BPIs religiously since late last spring has spared us from a great deal of index-speculation pain. After the anomalous nature of the war rally became apparent, I greatly reduced our reliance on sentiment (emotion-based) indicators and started watching pure technical (price-based) indicators including these BPI reversals.
Thankfully, this strategy has saved us from going heavily short since last spring. We have launched a couple of small exploratory puts trades periodically since then, but most of our speculative index-trading capital has remained in cash protecting us from the horrendous losses that many contrarians and bears have borne. These BPIs have enabled us to nibble but not yet sink our teeth, preserving our precious capital for the real top wherever ahead it may lie.
This week I would like to examine the Big Three indices relative to their key BPIs since last summer. The BPI reversal speculation theory becomes much clearer when viewed in graphical form on charts. The Dow 30, S&P 500, and NASDAQ graphed side by side help illuminate both the strengths and weaknesses of this 6% BPI reversal contrarian-speculation concept and can help us profitably tweak it to fit today’s anomalous markets.
The biggest and most studied Bullish Percent Index is the NYSE variant, the one I wrote about last summer. In this graph we compared the NYSE BPI to the Dow 30 blue-chip stock index. This may seem odd since there is both an NYSE stock index (NYSE Composite) and a Dow 30 BPI, but this cross comparison actually makes some sense.
While the NYSE BPI is the flagship BPI index, the NYSE Composite stock index is really not widely followed. I bet that over 90% of folks who consider themselves to be active investors and speculators cannot tell you where the NYSE Comp closed yesterday, for example. But the Dow 30, on the other hand, is probably the most widely followed stock index on the planet. Comparing the NYSE BPI with the familiar Dow 30 index grants us a better and more widely understood point of reference.
And while the Dow 30 has its own dedicated BPI, which I do follow as well, the resolution on the Dow BPI is very rough. With only 30 elite stocks in this index, each tick in the Dow 30 BPI runs a massive 3.33%. To get a 6% reversal in the Dow BPI, only two stocks have to surrender their P&F buy signals, not really a major representative sample.
The NYSE BPI, on the other hand, representing well over 3000 stocks or 100x more issues than the Dow 30, has a very fine resolution and is much better suited to examining technical trends lurking below the surface of the headline index numbers. Marrying this flagship BPI with the elite Dow 30 index seems appropriate in light of these concerns.
As you can see in the chart above, there has not been a single 6% reversal in the NYSE BPI since the war rally launched! We came close in early August after the NYSE BPI began to plunge as the Dow 30 grinded sideways above 9000, but the August rally turned the BPI right around and prevented the 6% reversal from materializing. Since then, we haven’t even come close to witnessing a 6% reversal in the key NYSE BPI yet.
These reversals are always rendered from the latest interim high in the BPI, so every time a fresh new rally-to-date BPI high is achieved, the 6% reversal benchmark is reset. Each of the L-shaped red brackets above measuring potential reversals illustrates this, with the 6% reversals that contrarian speculators seek gradually climbing to the right like steps on a staircase.
The latest NYSE BPI bull-to-date high of 78.8% was just achieved in late January, so we now need to witness this BPI reverse down to at least 72.8% in order to become interesting again. Until this reversal does indeed occur, there is no major technical evidence from the NYSE BPI that the P&F internals of this strong cyclical bull are failing. As such, contrarian speculators probably do not want to aggressively fight this thing without seeing the initial 6% NYSE BPI reversal become a reality first.
The NYSE BPI does present some unique problems though, as the character of this broad index is constantly changing. A growing number of NYSE components are not simple American common stocks anymore, but include foreign stocks, exchange-traded funds, real-estate investment trusts, and other hybrid vehicles that are not directly tied to US equity sentiment.
This slow dilution of the NYSE will probably cause the utility of the NYSE BPI to gradually fade over time, as a shrinking percentage of its components are actually the American common stocks that it seeks to measure. Nevertheless, for now the NYSE BPI remains the most celebrated and studied of the BPI indices, and contrarian speculators would do well to watch for its initial 6% reversal that may very well herald the end of this nearly year-long US equity rally.
Unlike the NYSE BPI, the S&P 500 (SPX) BPI has already witnessed two full 6% reversals during this war rally, but both proved to be temporary and failed to herald the end of the cyclical bull. We did launch an initial small exploratory index puts position on the first S&P 500 6% BPI reversal and watched it expire worthless, but nevertheless the SPX BPI still has much to offer for contrarian speculators.
The first 6% reversal in the S&P 500 BPI triggered last summer, and was a textbook-perfect example of a falling BPI betraying rapidly decaying technicals within the S&P 500. While the S&P 500 stock index itself was essentially grinding sideways in July and looked an awful lot like a major interim top at the time, its BPI was plunging and growing very interesting for contrarian speculators.
After retreating more than 6% last summer, the SPX BPI really did not fall far below its 6% line nor did it stay there long. Just as in the NYSE BPI above, the sharp August rally, which finally carried the mighty S&P 500 decisively back above the psychologically crucial 1000 mark, also turned its BPI around and erased the earlier reversal. By September a fresh new interim bull-to-date SPX BPI high had been achieved and a new 6% reversal benchmark had been set.
Interestingly, after this August rally once again the S&P 500 pulled back to its 50dma and the SPX BPI plummeted with it, barely reaching a second 6% reversal by late September. We chose not to trade on this second reversal since we already had an exploratory index puts position open after the initial reversal, and this decision proved to be the correct way to game this. The S&P 500’s second 6% BPI reversal lasted a whopping three days before the index started galloping higher again.
Today, in light of the latest unbelievable 88.8% SPX BPI interim high of January, the SPX BPI 6% reversal level is once again reset. Contrarian speculators are now focusing on an S&P 500 BPI level around 82.8% or so as the next major milestone of interest. As the September episode illustrated, these BPI reversals can happen quite rapidly once they begin, so speculators need to stay on guard even though the S&P 500 barely carved a new interim bull-to-date high this week. As this chart illustrates, sharp BPI declines often launch from new interim stock-index highs.
With the benefit of 20/20 hindsight, the 6% BPI reversal mark that is perfect for the NYSE BPI was a bit too aggressive for the S&P 500 BPI. There are a couple things that we could do as speculators to try to avoid getting caught in false 6% reversals that do not actually signal a major technical trend change in the S&P 500. These include expanding our reversal metric of interest and placing a minimum time duration requirement on the SPX BPI reversal.
In vertical-scale terms, the August BPI reversal ultimately measured in at 6.6%. It is also important to realize, however, that off this chart in June 2003 the SPX BPI hit 82.8%, which yielded a full SPX BPI reversal of 9.4% into August. From the July 80% high the SPX 6% BPI reversal only existed for 4 trading days. From the earlier June top the SPX 6% BPI reversal lasted for 5 trading days in July, after which it briefly recovered above 6%, and then for another 14 trading days in August.
The second SPX BPI reversal of September ultimately ran 6.4% and only maintained this 6%+ level for 3 short trading days. Other than briefly after the first SPX reversal measured from the June high not rendered above, this index has not managed to break decisively below its key 6% BPI reversal level, although it has been challenged.
So, going forward, speculators probably ought not to take a 6% SPX BPI reversal as seriously as they would the initial 6% reversal in the NYSE BPI. Maybe a reversal of greater than 6% should be chosen as well, although I am not emphatically willing to change this indicator yet after only one major signal failure last summer. In addition, speculators can consider waiting until the SPX BPI has reversed by more than 6% for some minimum number of trading days before acting, to ensure the reversal is for real.
Coincidentally the NASDAQ Composite BPI has already witnessed a 6% BPI reversal as well, although interestingly it failed to coincide with the S&P 500 BPI reversals above in terms of timing. The NASDAQ’s only rally-to-date 6% BPI reversal happened in the second half of November, well after the SPX reversals we noted above.
In NASDAQ terms, it is interesting to note that this hyper-speculative technology index did not witness actual 6% BPI reversals in either August or September like the S&P 500, although both times it came darned close. In early August, the NASDAQ Composite BPI fell by exactly 5.89% before recovering, ever so close to the 6% reversal level. I remember eagerly watching these numbers at the time, ready to immediately publish a Zeal Speculator Alert and launch trades for our subscribers if this key level was breached. But it held, and we made no trades.
Once again in early October the NASDAQ BPI came close to reversing, but only managed to retreat by 5.76%. A couple weeks later in late October the NASDAQ BPI fell again, but its reversal remained short of the 6% mark when it maxed out at 5.54%. It wasn’t until the later part of November when the NASDAQ BPI finally broke below the 6% mark, at which time we deployed another exploratory index puts position that we hold to this day.
Now as you can see above, from mid-September to late December the NASDAQ BPI plunged precipitously, ultimately falling by about 10.2%. With such a massive internal decay, fully 10% of the stocks of the entire NASDAQ Composite carving ugly technical patterns negating their P&F buy signals, the NASDAQ probably ought to have rolled over. But it did not! The highly speculative NASDAQ rallied strongly into the end of the year and January, carving a new bull-to-date interim high late last month.
Why did the NASDAQ rally just when its BPI was starting to look precarious? I suspect the answer may be seasonal. The January Effect on stocks is well known, as tens of billions of dollars of American employees’ retirement funds are sent by US corporations to mutual funds, which then in turn dump them into the markets immediately regardless of prevailing stock prices.
The NASDAQ buying in late December was probably anticipating this flood of retirement capital into mutual funds following the end of the year, while the January portion of our recent rally probably reflected this fresh capital actually bidding on tech stocks. Much of this seasonal buying pressure has probably abated though, as the NASDAQ’s recent plunge in early February to back down near December levels reflects.
With a brand new bull-to-date interim high of 77.8% carved in the NASDAQ BPI, our next 6% NASDAQ reversal will occur around 71.8% or so. As the NASDAQ BPI is so volatile and moves so rapidly, I suspect that this next 6% NASDAQ BPI reversal milestone will be hit as soon as we see another week or so of NASDAQ weakness.
Now that we understand how all three of the major US stock indices have behaved relative to their related BPIs during the war rally so far, we can draw some potentially useful conclusions as contrarian speculators.
The classic 6% reversal level is probably most suited to the NYSE BPI, not surprisingly the BPI in which it was originally developed. While the NYSE BPI has yet to witness a 6% reversal during this rally, both the S&P 500 and NASDAQ BPIs have already had one significant 6% reversal each. While these S&P 500 and NASDAQ reversals did not signal the ultimate interim top, they did alert us to underlying technical weakness and decay in the indices, which is important information to know.
While we could expand the 6% benchmark reversal level for the S&P 500 and NASDAQ BPIs, and/or decide that we will only heed these signals if they exist for a certain number of trading days, I am not yet convinced that this is necessary. The spectacular rally in US equities since last March from the amazingly high valuation levels at which it erupted is almost unprecedented. Indicators should be adjusted for more conventional situations, not weird anomalies. We need more data before making a final decision on loosening the classic 6% reversal milestone.
In the meantime, while we watch and wait and see how this rally and these BPI-reversal indicators will play out, a combination approach might prove useful. For example, rather than using only an S&P 500 or NASDAQ 6% BPI reversal, perhaps we should wait until we see at least two of these reversals trigger concurrently. Indeed, not long after the next major downleg begins in earnest, the NYSE, S&P 500, and NASDAQ BPIs will probably all simultaneously fall by 6% or more from their respective interim highs quite rapidly.
I suspect that our probability of nailing the major trend change marking the end of the war rally will increase if we hold out until more than one of the major BPIs retreat back down into tantalizing 6% reversal territory. We would need a major broad-market correction to accomplish this, so a sector correction like a technology reversal alone would not trigger this signal.
We are zealously continuing to monitor all of the major BPIs at Zeal, including the NASDAQ 100 and Dow 30 BPIs which were not analyzed in this essay. I am sure looking forward to heavily shorting this hyper-overvalued market again once we get some clear indication that this relentless rally’s ultimate top has been carved, and the BPI reversals will be a key tool that will help us accomplish this important goal.
In addition, in an upcoming issue of our acclaimed monthly Zeal Intelligence newsletter for our subscribers I would like to discuss index speculation in depth. This stubbornly persistent war rally out of a brutal Great Bear interim low has been very educational for all speculators and is helping me understand how to refine our grand index-speculation strategy to best attempt to capture the upcoming trading opportunities.
Our ZI letter will also continue to watch these BPI reversals as they evolve and recommend specific actionable index-options trades when appropriate.
Even though this war rally has been really hard on contrarians, the laws of markets, valuation, and sentiment certainly have not changed, and there will be a reckoning sooner or later. Reversals in the key Bullish Percent Indices are an important speculation tool to help alert us to early technical decay that will presage this major reckoning.
Adam Hamilton, CPA February 13, 2004 Subscribe at www.zealllc.com/subscribe.htm