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Stock Market Indicators, NEW HIGH-NEW LOW INDEX
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Stock and futures traders used to live like two separate tribes. They traded different markets and used different analytic tools. The wall between them began to crumble after stock index futures were created in 1982. Both tribes rushed to trade them. An astute trader owes it to himself to master the tools of both tribes.

Shrewd stock traders use Stochastic, moving averages, and other tools of futures analysts. Futures and options traders can time their stock index trades better by using stock market indicators. They include the New High-New Low Index (probably the best leading indicator of the stock market), the Traders' Index (TRIN), and several others.

How to Construct NH-NL

The New High-New Low Index (NH-NL) tracks the numbers of market leaders. It measures the number of stocks that have reached new highs or lows for the year on any given day. The stocks on the list of new highs are the leaders in strength, and the stocks on the list of new lows are the leaders in weakness. NH-NL confirms trends when it rallies or falls in gear with prices. It identifies tops and bottoms in the stock market when it diverges from prices.

The New High-New Low Index measures daily differences between new

highs and new lows. The New High-New Low Index is easy to calculate by hand, using information from the Market Diary section of most major newspapers.

NH-NL = New Highs - New Lows

New highs and new lows are reported by most data services in the United States . Make sure that your data vendor calculates new highs and lows over a 52-week period. Some use the ancient "calendar method" and calculate new highs and lows going back only to January.

Plot the New High-New Low Index as a histogram, with a horizontal reference line at zero level. On the days when there are more new highs than new lows, NH-NL is positive and plotted above the centerline. On the days when there are more new lows than new highs, NH-NL is negative and plotted below the centerline. If the numbers of new highs and new lows are equal, NH-NL is zero.

Crowd Psychology

A stock appears on the list of new highs when it is the strongest it has been in a year. This shows that a herd of eager bulls is chasing its shares. A stock appears on the list of new lows when it is the weakest it has been in a year. This shows that a crowd of aggressive bears is dumping its shares.

The New High-New Low Index tracks the strongest and the weakest stocks on the exchange and compares their numbers. It measures the balance of power between the leaders in strength and the leaders in weakness. This is why NH-NL is a leading indicator of the stock market. The broad indexes, such as the S&P 500, tend to follow the trend of NH-NL (Figure 37-1).

You can visualize the 2000 stocks on the New York Stock Exchange as a regiment of 2000 men. If each stock is a soldier, then new highs and new lows are the officers. New highs are the officers who lead the attack up a hill, and new lows are the officers who are deserting and running downhill. There are no bad soldiers, only bad officers, say the military experts. The New High-New Low Index shows whether more officers lead the attack uphill or run downhill.

When NH-NL rises above its centerline, it shows that bullish leadership is stronger. When NH-NL falls below its centerline, it shows that bearish leadership is stronger. If the market rallies to a new high and NH-NL rises to a new peak, it shows that bullish leadership is growing and the uptrend is likely to

Stocks making new highs for the year are the leaders in strength, and stocks making new lows are the leaders in weakness. NH-NL measures the direction and intensity of market leadership by comparing the number of new highs and new lows.

In the summer of 1987, mass bullishness rose to a high pitch, as the bull market roared into its final peak. It was safe to hold stocks as long as each new high in the stock market was confirmed by a new peak in the New High-New Low Index (A, B, C, D, and E). The August peak in the stock market was accompanied by a bearish divergence (E-F) in the NH- NL Index, giving a sell signal.

When the stock market declined in September, many traders went bargain hunting. Five years of rising prices had trained them to use declines for buying. NH-NL, meanwhile, pointed to a severe weakness. It peaked out at only 100 (C), indicating weakness. NH-NL turned negative in October (H). It gave repeated sell signals in advance of the historic crash.

continue. If the market rallies but NH-NL shrinks, it shows that the uptrend is in trouble. A regiment whose officers are deserting is likely to turn and run.

A new low in NH-NL shows that the downtrend is likely to persist. If officers are running faster than men, the regiment is likely to be routed. If stocks fall but NH-NL turns up, it shows that officers are no longer running.

Trading Rules

Traders need to pay attention to three aspects of NH-NL, listed here in the order of their importance: divergences between the peaks and bottoms of NH-NL and prices, the trend of NH-NL, and the level of NH-NL above or below its centerline.

The New High-New Low Index gives its best messages when it diverges from prices. This chart shows what happened prior to the 1989 mini- crash and how the recovery began.

The market reached a new peak in August (A), accompanied by a new peak in NH-NL, which indicated that the market was likely to go higher. The rally in September (B) was accompanied by a bearish divergence that gave a sell signal. The market struggled to a new high in October (C), but NH-NL made a lower peak, repeating its sell signal. NH-NL turned negative one day prior to the crash, forcefully confirming its sell signal.

The October low (D) was followed by a reflex rally ("a dead cat bounce"), and then prices twice retested their October lows (E, F). On both occasions, NH-NL made more shallow bottoms than in October. These bullish divergences gave buy signals, and a new uptrend began.

As long as a price peak is confirmed by a new high in NH-NL, the rally is likely to continue, even if it is punctuated by a decline. When low prices are accompanied by new lows in NH-NL, it means that bears are in control and the downtrend is likely to continue. Divergences between NH-NL and broad

market averages provide the best trading signals. A trend that loses its leaders is likely to reverse.

•  If NH-NL traces a lower peak while the market rallies to a new high, it
creates a bearish divergence. This shows that bullish leadership is
weakening even though the broad market is higher. Bearish diver­
gences mark the ends of uptrends. If the last peak in NH-NL is about
+100 or less, then a major reversal is probably at hand and it is time to
get short. If the latest peak is much higher than +100, then the upside
leadership is strong enough to prevent the market from collapsing.

•  If NH-NL traces a more shallow bottom while the market declines to a
new low, it creates a bullish divergence. This shows that bearish lead­
ership is shrinking, even though the market is lower. If the latest low
in NH-NL is near -100, it shows that the bearish leadership is
exhausted and a major upside reversal is near. If the latest low is much
lower than -100, then bears still have some strength, and the down­
trend may pause but not reverse. Keep in mind that bullish diver­
gences at stock market bottoms tend to develop faster than bearish
divergences at market tops: Buy fast and sell slowly.

The slope of NH-NL on any given day is defined by the trend of its bars for the last few days. When the market rallies and NH-NL rises, it confirms uptrends. When NH-NL declines together with the market, it confirms downtrends.

•  A rise in NH-NL shows that it is safe to hold long positions and add to
them. If NH-NL declines while the broad market stays flat or rallies, it
is time to take profits on short-term long positions. When NH-NL
falls, it shows that the bearish leadership is strong and it is safe to hold
short positions and even add to them. If the market continues to fall
but NH-NL rises, the downtrend is in question —it is time to cover
shorts.

•  If NH-NL rises on a flat day, it flashes a bullish message and gives a
buy signal. It shows that officers are going over the top while the sol­
diers are still crouching in their foxholes. When NH-NL falls on a flat
day, it gives a signal to sell short. It shows that officers are deserting
while the troops are still holding their positions. Soldiers are not
stupid —if the officers run, they will not stay and fight.

The position of NH-NL in relation to its centerline shows whether bulls or bears are in control. When NH-NL is above its centerline, it shows that more market leaders are bullish than bearish. Then it is better to trade the stock market from the long side. When NH-NL is below its centerline, it shows that bearish leadership is stronger, and it is better to trade from the short side. NH-NL can stay above its centerline for months at a time in bull markets and below its centerline for months at a time in bear markets.

5. If NH-NL stays negative for several months but then rallies above its centerline, it signals that a bull move is likely to begin. Then it is time to look for buying opportunities, using oscillators for precise timing. If NH-NL stays positive for several months but then falls below its cen­terline, it shows that a bear move is likely to begin. Then it is time to look for shorting opportunities using oscillators for precise timing.

More on NH-NL

Old analysts used to smooth NH-NL using 10-day and 30-day simple mov­ing averages. When a 10-day MA of NH-NL crossed above a 30-day MA, it gave a buy signal. When a 10-day MA crossed below a 30-day MA, it gave a sell signal. Raw NH-NL gives clearer signals, but if you still want to smooth NH-NL, it is better to use exponential moving averages.

The number of new highs and new lows is reported daily by the New York Stock Exchange, the American Stock Exchange, the Over-the-Counter Exchange, and the London Stock Exchange. Most overseas stock exchanges do not report these numbers, but a computer-equipped analyst should have no difficulty creating NH-NL for any market. Traders who use NH-NL outside of the United States get an edge over competitors who lack this indicator. You need to obtain one year's worth of daily data for every stock on the exchange you follow and update that file daily. Program your computer to examine your database each day and flag those stocks that have reached a new high or a new low for the past 52 weeks.

NH-NL does not work in the stock markets dominated by a handful of stocks. For example, hundreds of stocks are listed on the Milan Stock Exchange in Italy , but only 2 of them —FIAT and Generale — represent nearly 70 percent of total market capitalization. These two giants can override the rest of the market.

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