From the June 01, 2009 issue of Futures Magazine • Subscribe!

As smart money goes, so goes the market

Since the dawn of the financial markets, many traders have focused on one weighty question: What’s the smart money doing? The presumption is that there are smarter investors than you out there, whether by information access or analytical skill, or those that are simply so large their trades will move the market, and if you know where they are putting their money, you can follow and capitalize.

Of course, an institutional investor looking to quietly accumulate a large position would not broadcast it to the world. Another dilemma is that it could be just as reasonable to assume that another large investor is selling an equally large position at the same time the other one is buying.

So, what is an investor to do other than flip a coin and hope for the best?

Thankfully, there is a way to track the smart money in the equity markets. After each trading session and at the end of each week, financial print journals and a variety of online sources publish the results for the most active issues traded by volume on the New York Stock Exchange (NYSE), Nasdaq and American Stock Exchange (Amex). You just need to know what to do with that information.

THE ROARING 20

Smart money is in the market for the most liquid and highly capitalized securities available. Those funds must go into and out of the market via large blocks of stock. It isn’t practical for a multi-billion dollar hedge, or mutual fund, to attempt to buy $100 million worth of a low-cap stock selling for $2 a share.

In addition, while it is not possible to determine the intent of the buyers or sellers of the most active issues, whether volume reflects positions by long-term institutional traders with no visible exit points or hedge funds that have hedged their position, the most actives nonetheless reflect the cream of the crop of all issues traded. On a given trading day, the 20 most actively traded issues on the NYSE can constitute 30% to 50% of composite exchange volume. It follows that we should follow the volume leaders when creating a gauge of the internal strength or weakness of the market.

Once the volume leaders are recorded, a simple tally of the 20 most active positive issues vs. the negative issues will yield a net number that can be added to a classic advance/decline line. This advance/decline line is called the most actives advance/decline line (MAAD).

What sets MAAD apart from other advance/decline indicators is it is selective about what it includes. In the traditional advance/decline line, a small stock that trades only 15,000 shares during a session and a wimpy 100,000 shares on the week, might still be counted as an “up” against, say, XOM that may have traded 40 million shares on the same trading day and over 200 million on the week.

The essence of using MAAD is to determine how the indicator is performing relative to broad market averages. If MAAD is rising along with the market, the indicator is suggesting that smart money likes equities. If the market enters into a consolidation over a period of weeks and MAAD remains resilient and bounces back on recoveries, the indicator is suggesting that smart money is accumulating on weakness. On the other hand, if MAAD falters into market rallies or accelerates into market declines, it’s likely the smart money is selling, and maybe in earnest. Key examples of that bias occurred before the 2000 and 2007 major market highs (see “Before the fall,” left).

On the critical front, because MAAD is a net advance/decline indicator rather than a money flow indicator, it will not reflect the extent of a move because the indicator is directional. Because the indicator registers a maximum of 20 units up or down in our study, it will not reflect extreme market moves even though the indicator remains maximum negative and moving in the direction of the market trend.

The ‘87 Crash was an example of this phenomenon. Massive movement in the market was not accompanied by significant deterioration in MAAD, but such action also could be interpreted as a positive divergence in favor of MAAD. Pure money flow, on the other hand, which weights price with a volume input, can measure market extremes, but also has its faults because a big volume issue can skew overall cumulative results. Nonetheless, MAAD has an excellent record over the past three decades of identifying key turning points in the market on both the intermediate and major cycles.

HISTORICAL PERFORMANCE

While few suspected that the greatest bull market in history would follow nearly 16 years of stock market consolidation from early 1966 through mid-1982, there were signs into the August 1982 lows that smart money had been snapping up stocks for some time (see “Stockpiling,” left).

While the S&P 500 sold down to within 40 points of its March 1980 lows in August 1982, MAAD held substantially above those March lows. In fact, MAAD punched to new intermediate-term highs in March 1981 and again in May 1982 before powering to a new all-time high in October 1982 just as the market confirmed new price highs in the S&P 500. Clearly, pent-up demand in the market was breaking loose.

During the first serious pullback in the market from October 1983 through July 1984, MAAD gave virtually no ground on the downside. Smart money was accumulating stocks on weakness and pushed the indicator to a new all-time high in May 1984, nearly three months before the general market followed suit.

In the fall of 1987, the new bull market had been underway for nearly five years. Old paradigms such as “you can’t lose money buying stocks now” were re-booted, and new ones — “it’s gonna be different this time” — were coming into vogue. Small investors were beginning to climb back on board the Wall Street bandwagon. The age of Gordon Gekko was in full swing.

Within weeks, the new euphoria had turned from glee to gloom. In just over two months, the Dow Jones Industrial Average lost nearly 41% from high to low while the S&P 500 lost almost 36%. Amid that carnage, some pundits were not only predicting a new bear market but were certain the world was on the brink of a new, worldwide depression. Visions of 1929 were surfacing and many investors were bailing out.

While market prognosticators were setting up for a new financial Armageddon, MAAD told a different tail (“No disaster here,” right).

Like the broad market, the indicator peaked into the third week of August 1987, declined slightly, then rallied feebly into the first week of October. When the several days of concerted selling developed into the October “crash,” MAAD was also net negative. But within five months, and during the week of March 18, 1988, MAAD powered upward to a new all-time high and led the S&P 500 to a new peak by nearly 16 months, while suffering no serious setbacks until the correction that developed in the fall of 1990. Smart money was on a buying binge again.

Both the sharp correction in the fall of 1990 and the year-long lateral correction that began in February 1994 created no lasting selling bias in MAAD. In the first instance, whereas the S&P and the broad market averages broke intermediate-term support levels put in place earlier in 1990, the indicator failed to suggest that smart money was exiting the market. In fact, the indicator rallied to a new high with the broad market after underscoring the positive divergence in the fall of 1990.

Second, while the 1994 consolidation coincided with a mini-recession and some talk of a new bear market, MAAD rallied to a new bull market high the third week of August 1994 and nearly five months before the broad market made new highs to suggest, once again, that smart money was a buyer. Thereafter, for more than five years, MAAD led, or remained in sync with, the powerful and secular bull market.

At least until the week ending May 21, 1999.

CLASSIC DIVERGENCE

Classic indicator statistical divergences leading into and just after the major market peak in 2000 were all over the map. The NYSE advance/decline line made a high in early April 1998 and 32% below the final peak in the Dow Jones Industrial Average in January 2000 and more than 38% below the high in the S&P 500 index at 1552.87 in March 2000. Monthly momentum did a bit better by peaking in July 1999, but then flip-flopped back and forth between slightly positive and slightly negative for most of the ensuing two-year bear market. The advance/decline line for NYSE advancing/declining volume didn’t do much better and peaked the third week of May 2001 into the end of the first reflex rally of the new bear market. Using advance/decline alone, the less savvy might have concluded that the bull trend was resuming. Not so.

Only MAAD peaked the week of May 21, 1999, into the latter stages of the bull market (see “Before the fall”). The indicator then moved steadily lower for the better part of the next four years until April 2003 when its defined uptrend was terminated with higher index prices. In fact, MAAD had continuously confirmed a hefty 275% gain in the S&P 500 from February 1995 until the May 1999 peak. MAAD ultimately topped out just 15% below the final high.

MAAD ANOMALY

MAAD had its only significant statistical exception in the 30 years of historical data used in this study during the eight month basing period that followed the price bottom of October 2002. MAAD, reflecting smart money sentiment, dipped to a new low during the first week of March 2003. Then, on price strength in the broad averages, the indicator quickly caught up and broke its downtrend in mid-May 2003. Two months later, intermediate resistance was fractured and MAAD confirmed the new, longer-term uptrend.

Whether the failure to create positive, divergent action into that 2002 low was a stumble or whether it was prescient as the market ultimately moved toward those fateful highs in the fall of 2007 we’ll leave to other analysts. What ensued reflected not only developing negative potential into that 2007 market peak, but eventually underscored the financial disaster that followed.

Still, once the new “bull” was underway, MAAD was decidedly in step with the broad averages and continued in that confirmation mode for nearly three years. When the market entered into a relatively normal 4.8% pullback that lasted from mid-May through the first week of June 2006, MAAD broke intermediate support to create an early indication that smart money might be getting nervous. The indicator subsequently recovered, however, and rallied to a new high the week of July 13, 2007. But that was it. Three months later, the major averages put in place their major highs and the market entered into a catastrophic decline exceeded only in damage by the 1929-1932 bear market.

Notice how MAAD performed from early 2003 through late 2007 relative to its 2000 highs and to the market averages. Not only was the MAAD recovery rally feeble while the S&P 500, Dow 30, 20, 15, and the Russell 2000 rallied to new all-time highs, but MAAD recovered less than 50% of its 2000-02 bear market decline. Was smart money having doubts about the viability of the five-year rally?

When MAAD peaked in July 2007, after failing to rally with the averages to new highs despite price strength into October 2007, the handwriting was on the wall. Both MAAD and the market subsequently cracked five-year-old up trendlines late in 2007 and, in spite of feeble rallies, have demonstrated no appreciable improvement since.

WHAT NOW?

Into the first weeks of the second quarter of 2009 MAAD remained decidedly negative in the face of strong gains in the market that had moved up from new lows made in early March 2009. But would the market get hung up on resistance coincident with near-term over-bought readings and then head south again? Or was March the final low?

Since the one historical anomaly created in 2002 when MAAD failed to set up a positive divergence in the face of a bear market low was canceled by the massive positive divergence at the 1982 bear market low and the start of the secular uptrend, evidence is limited using historical instances for a confirmed major trend low. Only short-term MAAD readings demonstrated an early upside attempt just days into the New Year to break a 15-month-old downtrend (see “Short-term signs,” left).

There was another upward downtrend fracture in early March. While those two short-term challenges would not be enough to terminate the defined downtrend in the larger cycle MAAD initiated in the fall of 2007, they could be a first hint of some recovery, or at least until deeply oversold intermediate-term readings are neutralized. Then the larger and more powerful bear trend would have to once again prove its viability — or not.

While it could be argued that the decline in MAAD since October 2007 was less severe than the decline in the indicator from May 1999 to the 2002 low, it is the direction of the indicator that is more relevant than the extent of the move. The indicator also has yet to make a confirmed low, action that has yet to preclude further price weakness in the major averages and new lows. We need to see either a positive bottoming divergence in MAAD or an upside trendline break.

Among a spectrum of market indicators that practitioners use to estimate what smart money is doing, MAAD is one way to consistently measure whether big investors are on the buy or sell side of the market. Over the past 30 years, the indicator has had a remarkable record of defining the ongoing status of bull and bear trends while providing either leading or coincident confirmation of a major change in trend.

Robert McCurtain is a technical analyst, market timer and private investor based in New York City. He can be reached at traderbob@nyc.rr.com.

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