How To Determine Market Health

5 Tools to help you assess the stock market environment.

Traders make most of their money in an easy dollar environment when the markets are supportive. The key thereafter is to preserve profits in volatile and choppy markets.

If the drawdowns take away most of your profits, you would not be too different than a buy-and-hold investor. In that case, devoting time and effort to trading is a worthless exercise.

Therefore, it’s essential to understand the health of the market and adapt the trading strategy to different market conditions.

My personal strategy for example, by default adapts to poor market conditions by reducing positions size, reducing the number of positions, and descaling from any use of leverage.

There are however several tools to assess the health of the market. Some of them also deliver warning signals or signals of strength that aren’t clearly visible in the index or talked about in the news.

Here are five such tools that you can use to assess the health of the market.

Index Technicals

The most basic indicator of market health is the technical setup of the index. This includes candlestick analysis, price-volume action, stage of the trend as per the Dow Theory, price behaviour toward trendlines and moving averages, and the state of indicators like the relative strength index (RSI) and the moving average convergence divergence (MACD - My Favourite).

Most indicators are laggards and show weakness or strength when most of the action has already happened. Therefore, you should be proactive and skilled in interpreting the indicators. If you wait for the indicator to confirm the state of the market, you could be too late in acting.

The best way to deal with the conundrum is to choose the least lagging indicators like candlesticks, price volume and support/resistance lines which often lead the health check of the market. Once these indicators flash warnings signs, exercise caution while keeping an eye on other indicators.

As the weakness starts appearing in other indicators, you would know that it’s time to preserve profits and be less aggressive.

Although my Trading approach reacts by default I do look for some technical aspects for my longer term Index positions, for example a recent S&P chart I posted in our group shows potential support off the 50 week moving average, this could be a good time to add some positions, or equally if price breaks through that support, it could be a sign to be very cautious.

S&P 500

Net new highs / new lows

This market-wide tool shows the ratio of the number of stocks hitting new highs to the number of stocks hitting new lows on a daily/weekly basis.

When the markets are raging new highs every day, there will be more numbers of stocks making new highs than the number of stocks making newer lows. This would continue for a long time and the graph will go up steeply in the beginning, will plateau towards the peak, and start declining as the market turns.

When the new highs list is getting shorter and the new lows list is expanding, it can be a sign of possible trouble. As this happens, traders become much more risk-oriented and only take trades that offer the best reward for each pound of risk.

It must be noted that the graph takes its own time to peak, plateau, and decline. Therefore, you must not jump to quick conclusions and always corroborate the results with other market health indicators to form a view.

The S&P daily chart below as of today (12th Oct 2022) shows a net negative 66, meaning there are more stocks making new lows than there are highs.

Interestingly however, there is a divergence between the high/low ratio of singular stocks, which is increasing on the chart, just as the index made a new low, again suggesting a possible time to re-enter.

Percentage of stocks above MA 50

This tool measures the percentage of stocks above their respective 50-day moving average. This metric helps assess the short-term health of the market and is helpful especially when the markets are going through an intermediate correction in a long-term uptrend.

When the percentage of stocks above their 50 DMAs is a significant majority, running into 80% and above, the market is said to be overbought and ripe for a pullback. Similarly, when the number is too low, going below 20%, the markets may be ripe for an uptick.

This number is a leading indicator of market turns when the pain in the markets is not visible in the index movements. The indices, however, cave in sooner or later when this tool indicates trouble.

As of today (12th Oct 2022) the green line in the chart below shows that a near 10% of stocks are above their 50 MA, again suggesting another consideration for an entry to the long side.

Percentage of stocks above the MA 200

This tool measures the percentage of stocks above their respective 200-day moving average. The metric is important to assess longer-term trends that last for a year or more. This percentage also swings from one extreme to the other and hence works like an oscillator.

Whenever a large majority of stocks in the market are above their 200-DMA, that construes as a long-term uptrend and when the majority is below the moving average, it construes as a downtrend.

Traders position themselves appropriately on the extremes, becoming cautious when the percentage is plateauing and starting to decline and aggressively looking for trades when the percentage is bottoming and reversing.

Again as of today, we can see that a near 20% of stocks are above their 200 day moving average, clearly indicating a downtrend, however this being at the extreme end, again suggests a potential bottoming in the market and an opportunity to take a position.

Your Trading performance

Though your own trading performance isn’t an explicit tool to assess the market health, it works quite well by pushing you out of the market in turbulent times and making you aggressive in good times (as mine does)

Good markets take all the stocks up with three-fourths of the market participating. This essentially means that the odds of you being right in your trades are quite high. Though that may not be 75%, because a lot depends on the timing of your trade and stop losses, it is however easy to assume that you could be right more than half the time.

As the market turns, three-fourths of the stocks follow the primary trend (downtrend), and the odds of you being right on the upside go down even further, declining to less than 20%. Trading in that environment will often be a losing proposition.

The equity profile of my strategy below shows how this may look through various cycles. Since the turn of 2022 (Global Crash) for example I have seen a small relative drawdown, whereas through a more favourable environment equity growth is considerable. This is all about trading appropriately when the markets are conducive.

The right strategy is to keep assessing the results of your last batch of trades, for me I use 30. If a large majority are hitting stop-losses, you can conclude the environment is hostile and reduce your position size, quantity of positions, or stop trading altogether until you see conditions improving.

When going from full cash to trading, start small, take progressive exposure, and keep assessing the performance of the trades you take. When the large majority start to do well, increase your position size and gradually move to 'sensible' margin if conditions keep on getting better. I never go above 2.5 to 1 margin.

Recession Indicator

Another interesting indicator is the recession probability chart below. The lower orange line represents the probability of a recession, and a reading above 80% very often correlates to a market bottom shown in the chart above the indicator.

Today we are over 90%.........

Conclusion

The importance of staying on the right side of the markets has been proven time and again. The more you try to fight the market, the more damage you will do to your trading career. Therefore, it’s important to ready your armour to assess the market health and keep going back to the analysis on a regular basis.

The ability to outperform the market in good times and not give back much in bad times is a superpower in trading. It’s okay if you aren’t there yet. The more you practice the better you will get at it. So, keep on it, follow rules, be disciplined and keep respecting risk to be in the game for life.

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