More on T2108

Posted by downtowntrader | 2/23/2009 10:14:00 AM | 0 comments »

Here is more on the T2108 indicator. The following is from an article I wrote that was never published.

The use of indicators varies almost uniquely from trader to trader, with some using them for actual trade signals, and others using them to help identify divergences. Some indicators are considered leading, while others are lagging. Of course all indicators are technically lagging, since they are derived from price, volume, or both, but how they're used is the key. I tend to use indicators as gauges in helping me determine what trend a stock or the market is in. Funny enough, the indicator I am writing about is surely a lagging measure, but I use it as a leading indicator. It's quite a conundrum that a lagging indicator can provide leading signals, but if you understand that what most of technical analysis is doing (measuring levels of psychological elements such as fear and greed), then it makes sense to look for extreme readings in either emotion to tilt the odds in your favor. If you can identify when one group is getting carried away, then you can use it to your advantage in getting in or out before the masses realize what is happening.

The indicator I am speaking of is T2108 which measures the percentage of stocks trading above their 40 day primary moving average. This is obviously lagging, since it is measuring Stocks versus their own lagging indicator, but I think it is very useful during times of extreme fear and greed. The way I use this indicator is to watch for moves to either extreme. The levels to watch are 80 percent on the upper end and 20 percent on the lower end. When 80 percent of stocks are trading above their 40 day moving average, it usually means market participants are aggressively bidding up stocks in a bullish environment and there is no fear in sight. Levels above 80 are usually not sustainable, but it's not necessarily a warning that things will come crashing down around you (although that did in fact happen in October). Sometimes the markets will continue higher as T2108 quietly turns lower. It's this divergence of new market highs, combined with lower readings in this indicator, which warns you the markets are losing steam. A good example of this was during the intermediate high in July 2007. T2108 hit over 80% a couple of times in April, yet as the markets made new highs in late July, T2108 was floundering around the 50% level. That was a clear divergence, and a not so subtle clue that the market was advancing with decreasing participation.

Reading lows is much more cut and dry. Any reading below 20% signals high levels of fear in the market place. While the markets won't necessarily turn on a dime, there very few instances where the markets hang around under the 20% area for a sustained period. Once the markets are in this area it makes sense to lighten up on shorts and start being on alert for a bottoming process, even if only on intermediate timeframes. Even in bear markets, the rallies from oversold levels such as these are quite tradable. If you compare T2108 to a market symbol, you will also notice that these levels have historically been great times to enter the market. I won't list all the instances, but any reader interested can hit CTRL-C in Telechart and punch in SPY,QQQQ, etc. and scroll back in time. It's interesting to see how these levels react during different periods in time, such as the months following Black Monday and surrounding the beginning and end of the Nasdaq Bubble.

This was written back in December 2007, so it is interesting to look back and see how this indicator, much like any indicator, only serves as a warning. There will be times where the markets will remain overbought or oversold far longer than what would seem logical. Fear and Greed are powerful emotions, and at extremes can turn reasonable people into a raging mob. The entire month of October 2008 had a reading averaging near 5%. This is amongst the worst periods ever. Currently, T2108 is near 14%. The question is are we returning to a more normal reading, or are we headed towards another extreme reading like we had in October. I am guess we are returning to more typical levels, which would point to an intermediate term low being put in here for a few reasons. The VIX is well off it's prior highs, even as the markets are testing their lows. It could be that volatility is regressing a little closer to the mean, and while it will probably remain elevated from the past few years zombie like levels, it should remain well off the panic driven highs of 2008. I won't pretend to have a crystal ball, but what happens if the Great Depression Part II, doesn't come to fruition? Regardless of whether we are near the bottom or not, this indicator is warning us that the markets are getting overdone on the short side.

Good Trading,