Introduction

New High and New Low data are widely used in analyzing the stock market on a technical basis. New Highs and New Lows, much like advances and declines, illustrate the level of participation in the market, and are a guide to internal strength or weakness of the market. In fact, New High/New Low data are often considered superior to advance/ decline data because to register on the New High/New Low list, a stock usually has to travel farther; whereas a stock only has to be up or down 1/8 to register as an advancing or declining issue. Thus, internal strength is accompanied by an expanding list of New Highs, while internal weakness is accompanied by an expanding list of New Lows.

This paper will explore the use of Sector New High and New Low data for spotting changes in sectors of the market. I use some divergence analysis, momentum and/or relative strength analysis in an attempt to quantify buy and sell signals. I believe this study is pioneering and gives technicians another tool for analyzing the markets.

Divergence analysis is an important element of technical analysis, but interpretation sometimes invokes a high degree of subjectivity.

Divergence Analysis

Turning points in the markets are often led by changes in various momentum indicators including rate of change analysis, relative strength, advance/decline measures and, of course, New High minus New Low measures. New High minus New Low oriented indicators may provide better entry and exit points to the stock market because, in my opinion, they have a tendency to lead the broad market averages. For example, as a bull market matures, a majority of stocks will stop posting New Highs, while a narrow list of stocks continues to carry the market averages and/or sector indices to a higher level. Similarly, when a momentum indicator diverges, we receive preliminary warning of a possible trend change. A divergence occurs when a price index makes a high unaccompanied by an underlying indicator. A divergence also occurs when a price index makes a low and is unaccompanied by an underlying indicator. The first is a bearish divergence, while the latter is a bullish divergence. Divergence analysis will be used in this paper to some extent with respect to New Highs and New Lows.

Momentum & Relative Strength

There are two ways of looking at momentum: as a measure of rate of change and as a measure of internal market vitality. Rate of change is more suitable for measuring a price average, while certain measures of internal strength are better applied to monitoring market indicators.

One of the tools used frequently in technical analysis is relative strength. Relative strength measures how well a stock and/or market is performing relative to another stock and/or market. A rising relative strength ratio implies improving performance, while a declining relative strength ratio implies weakening performance. In this paper, I use this concept of "relative momentum'' to generate buy and sell signals using Sector New Highs and New Lows. This, to my knowledge, will be the first time relative strength has been used in conjunction with New High/New Low data.

New High/New Low data have usually been used as a momentum measure. In other words, as a market moves higher, New Highs should expand and New Lows should contract. If a market makes a new high and the New High list contracts, this is regarded as a sign that internal momentum is slowing. The rate at which the New High list expands is also critical in determining a market's internal strength. During the initial stages of an advance, New Highs should expand rapidly. The longer the duration of the expansion in New Highs, the longer or more durable the rally.

The New High/New Low list offers many possibilities for analysis. lnvestor's Business Daily's New High/New Low list will be used as the source of this analysis.

Sector Analysis Using New High & New Low Data

Investor's Business Daily divided its New High/New Low list into various sectors (30 in all) starting on July 26, 1991. The limited history is a shortcoming, but it is still enough to draw some reasonable conclusions. Four sectors will be analyzed: Banks, Energy, Medicals, and Utilities.

The form of this analysis is twofold. First, a 10-day moving average was taken of the Net New Highs for each sector (this will be referred to as the NNH throughout the paper). Divergence analysis is then used to gain some insight. Admittedly, the insight is limited due to the fact that divergence analysis tends to he more subjective than objective, but the NNH was still useful in some cases.

Second, I introduce a new term called the RSH, which is the relative strength of a sector's New Highs. It is calculated by dividing the number of New Highs in a sector by the number of New Highs in the market. A 10-day moving average of the RSH is then taken and used for the analysis.

Lastly, I also introduce another term called the RWL, which is a relative weakness of the New Lows in a sector relative to the total New Lows in the market. A 10­day moving average of the RWL is then taken and used for the analysis.

The term "relative strength" in the RSH refers to a rising number of New Highs in a sector relative to the total number of New Highs in the market. The term "relative weakness" in the RWL refers to a rising number of New Lows in a sector relative to the total number of New Lows in the market. The RSH and the RWL more accurately measure the percentage of New Highs or New Lows in a particular sector to the total number of New Highs or New Lows in the market.

The RSH is used to generate the buy and sell signals, while the RWL is used to gauge the degree of weakness in a sector. The RSH rises quickly when a sector is strong and descends quickly when a sector corrects. This happens because stocks of a particular group tend to rally and correct together. Corrections are healthy as long as New Lows do not expand to any great degree.

The four sectors chosen are presented with a chart of the sector index, a 10-day moving average of the sector Net New Highs (NNH), a 10-day moving average of the sector New Highs relative to the market New Highs (RSH), and a 10-day moving average of the sector New Lows relative to the Market New Lows (RWL). The parameters used for the studies are as follows:

• The NNH will be used mostly for subjective divergence analysis. The divergences in some instances precede buy and sell signals given by the RSH.
• The RSH gives a trading buy signal by moving to or above 7. In other words, when 7% of all New Highs in the past 10 days on average belong to a particular sector, a buy signal is given. A trading sell signal is triggered when the RSH moves to or under 4 (4%) after being at or above 7.
• The RWL will trigger an alert when it moves above 10 or when 10% of all the New Lows in the past 10 days on average belong to a particular sector. The RWL above 10, however, does not supersede the RSH in the buy mode. The RWL above 10 does mean that the risk in a sector is rising and that a more selective stock selection approach should be used for that sector.
• Aggressive trading parameters are also established using the RSH. In this case, the RSH has to generate a new buy signal (the RSH has to move back to or above 7 from a level at or below 4). Once in buy mode, an aggressive trade is only activated when the RSH moves above 15 and drops by half. For example, if the RSH rises to a peak of 18.4, then a sell signal is given when the RSH drops to or under 9.2. It is only a sell for aggressive traders. The original position is not closed out for investors until the RSH is at or below 4.

An explanation of the parameters is appropriate before going on to the results. The parameters were calculated as follows:

1. The RSH was developed by dividing 100% by the 30 sectors. The rationale behind, dividing 100% by 30 is that if each of the market sectors were to all post the same number of new highs at the same time, each sector would make up 3.33% of the total Market New High list. This 3.33% gives us a benchmark number on which to base the RSH, even though it is understood that it would be a rare event, even impossible, for all 30 sectors to post the same number of New Highs simultaneously.
2. The 7 parameter of the RSH was developed by doubling 3.33% to 6.66% and rounding up to 7. The 7 is more than twice the 3.33 benchmark percentage and offers more satisfying proof of sector strength.
3. The 4 parameter of the RSH was developed by simply rounding the 3.33 benchmark percentage up to 4. Rounding up enables the investor to sell before the sector drops under 3.33, to retain a better portion of the profits or to limit the losses.
4. The 15 for the aggressive trades was chosen because 15% of the total number of New Highs is better than four times the 3.33 benchmark percentage and is considered very strong momentum. Once that peak number drops by half, enough of the momentum has been exhausted for the purpose of aggressive trading.
5. The RWL of 10 was selected simply as a round number made up of 3/30ths of the sectors. Ten percent is significant weakness for any particular sector and is about 3 times the 3.33 benchmark percentage.

Results

The results for the four sectors, the Bank sector, the Energy sector, the Medical sector and the Utility sector are presented in the following pages. Note that since the Investor's Business Daily database started on 7 /26/91, three of the sectors were already in buy mode at the inception (see tables 1, 3 and 4). Note also that the results are as of 8/30/96.

Bank Sector

The Bank sector has given six buy signals and six sell signals. At the inception of the database, the RSH indicator for the Banks was in buy territory. The sell signal was activated on 12/21/91. The first buy signal was on 12/26/91 and the first sell signal on 9/14/92. The profit was 7.80%. The results for this sector are summarized in table I.

Chart 1 of the Bank index appears with the accompanying three aforementioned indicators: the NNH, the RSH, and the RWL.

The NNH depicts a few divergences that were helpful in the early detection of some corrective pressures for the Banks. In the three instances indicated on the NNH chart, the divergences led to corrections and were ultimately confirmed by sell signals given by the RSH. These instances are pointed out in the chart using the parallel lines. The subjective nature of divergence analysis makes it difficult to come up with consistent conclusions, but used in conjunction with the RSH it presents a vital guideline. The NNH can come before a sell signal, but it is not the sell signal itself. Note that the divergences only preceded 3 of the 5 sell signals given by the RSH.

The RSH chart depicts the indicator used to generate the buy and sell signals. By way of review, a move to or above 7 from a level at or below 4 generates a buy signal, while a move to or below 4 from a level at or above 7 generates a sell signal.

The chart can also be used to show how dominant a sector has or hasn't been. The Banks, for example, have had five instances since 1991 where the RSH was above 15. This means that the Banks made up at least 15% of the total number of New Highs on average over a 10-day period on five occasions in the past five years. They have been leaders.

The RWL can be used to search for deeper problems in a sector. For example, if a sector dominates the New Low list it is perhaps indicative of more serious structural problems. A reading above 10 on the RWL is indicative of a sector that should be approached more carefully. The Banks have not had such a reading of 10 on the RWL since the inception of this database further accentuating the sector's strength.

The results of the buy and sell signals are detailed in table 1. Three out of six trades (50%) resulted in profits. The average return on the Bank Index for all six trades was 12% versus 6.9% on the S&P 500 for the same period.

The aggressive trading results were even more impressive . By way of review, aggressive trades are activated when the RSH rises above 15 and drops by half from the peak level.

Four of the five (80%) instances had positive results. More importantly, however, each aggressive trading result beat the S&P 500 for the same comparable period. This is a 100% track record and is true for each sector analyzed in this paper. The average profit for the aggressive trades in the Banks was 14.3% versus 4.1 % for the S&P 500.

Energy Sector

The Energy sector was an interesting sector to analyze because it gave more buy/sell signals (9) than any of the other sectors reviewed in this paper.

The Energy index and accompanying NNH, RSH and RWL are found in chart 2.

The NNH provided insight into two of the nine sell signals generated. A look at the NNH, however, also shows a noticeable expansion in the total number of Net New Highs in 1993 and again in mid 1995 to the present. The Energy sector has been among the best performing in 1996.

The RSH provided the buy and sell signals. Chart 2 shows why there were so many signals given. Many of the holding periods were short and not very profitable. In fact, notice that the Energy trades only outperformed the S&P 500 in 4 of the 9 ( 44%) instances.

The RWL moved above 10 on six different occasions since 7/26/91. Notice that the RWL has not been above 10 since mid 1995, further accentuating the Energy sectors strength in 1996.

The results of the buy and sell signals are detailed in table 2. Five of the nine (56%) trades resulted in profits for an average gain of 2% versus 1.4% for the S&P 500. The total return of the nine buy signals was .12% versus 1.25% for the S&P 500. The results are not very compelling for the Energy sector, but the S&P 500 did not fare much better.

The better results, as in the Bank sector, are the aggressive trading results. The RSH indicator moved above 15 twice. Both instances yielded profits that outpaced the S&P 500. The average aggressive trading return for the Energy sector was 8% versus .4% for the S&P 500.

Medical Sector

The Medical sector, because of its growth orientation, has very different charts than the other sectors analyzed. The medical sector has given four buy signals and five sell signals (see details in table 3).

A review of the NNH (see chart 3) reveals no divergence which preceded a sell signal. This lack of a divergence, however, is not a reason to disregard the NNH altogether. Note that the NNH expanded broadly in 1995. At the very least, the NNH can be used as reinforcement of the strength in the RSH.

The RSH chart was used to generate the buy and sell signals (see chart 3). Note that four times since 1991, the Medicals encompassed better than 15% of all New Highs being posted on average over a 10­day period as opposed to five times for the Banks. When the Medical sector had its highest RSH, it took almost two years to generate a sell signal (7/8/94 -6i20/96) and produced a return of 82.3%.

The RWL is where the most notable chart differences show up. The RWL was above 10 on several different occasions. In fact, the RWL went above 10 twice during that two year period, where the RSH did not give a sell signal. Recall that the RWL above 10 does not generate a sell signal. The RWL is merely used to gauge whether or not the risk in a sector is increasing. A reading above 10 is used to consider more careful stock selection in the sector.

The results in the Medical sector are displayed in table 3. Four of the five trades generated profits for an average gain of 31.3%. The average return of the five trades was 24% vs. 12% for the S&P 500.

The aggressive trading results were, once again, impressive. The RSH was above 15 on four occasions. When the RSH dropped by half from its peak value, a sell signal was given. The average gain was 16.5% versus .6% for the S&P 500.

The reason there are only two aggressive trades even though the RSH was above 15 on four different occasions, is that only two of the four instances above 15 were part of a new buy signal. Notice that the aggressive trade was closed out on 1/10/95, while the longer term trade was closed out on 6/26/96, about 1 1/2 years later. In other words, after the aggressive trade was closed out, there was no sell signal followed by a new buy signal.

The Medical sector had the highest and most prevalent RWLs above 10 (14 times). The growth characteristics of the group make selloffs more violent. The higher betas and the greater focus on earnings are reasons for the deeper selloffs. Banks and Utilities have lower betas and are interest sensitive to some extent; Utilities more so than Banks during this period. Energy stocks are greatly influenced by energy commodity prices and to a lesser degree, earnings.

Utility Sector

Lastly, I reviewed the Utility sector. The Utilities had six buy signals and seven sell signals (see results in table 4). None of the returns proved to be outstanding, but 4 out of the 6 (67%) were positive.

A review of the NNH showed two divergences which led to declines. Indeed, the second divergence preceded a severe decline of 30%. While divergence analysis is difficult to quantify, an analyst can at least be somewhat alerted to the fact that something in a sector may be changing, as in this case the 30% bear market decline in the Dow Jones Utility Index.

The RSH chart shows something different, not seen as clearly in our previous sector observations. During the deep selloff in the sector in 1994 and the subsequent stabilization period, notice that the RSH started to perk up (see points A, B, and C in the RSH section of chart 4). The implication of this is that as the New Low list was being dominated by Utilities, some were actually showing up on the New High list as well. These stocks were the early leaders out of a deeply oversold condition and indicated that the sector had seen its worst. Afterwards, the NNH started to show higher lows and the RWL dropped off dramatically. Both indicated that down­side pressure in the group had eased.

The results of the buy and signals, much like the Energy Sector, were not very compelling. Five of the seven trades were profitable. The average return of the seven buy/sell signals for the Dow Jones Utility Index was 2% vs. 2.8 for the S&P 500.

The aggressive results, however, were a bit better. There were three instances where the RSH was above 15. The average aggressive trading gain for the Utilities was 3.6% versus 2% for the S&P 500.

Conclusion

The four sectors shown here are 4 out of 30 such sectors in Investor’s Business Daily. These sectors were chosen because of their different characteristics: Banks are characterized as value/growth, Energies are considered value/growth, Medicals are considered growth, and Utilities are considered value.

The work I have done here is in its infancy. Divergence analysis, while subjective, will always be used by technical analysts to gain additional insight. The RSH and the RWL, however, attempt to quantify meaningful changes in a sector.

There are certain weaknesses to the methods outlined in this paper. First, it is possible that different parameters work better for different sectors.

Second, the buy and sell signals don’t always come early. The signals are usually timely enough to generate a profit or keep losses to a minimum, but in some instances a lot is left on the table.

Lastly, the sectors were developed by Investor’s Business Daily and are somewhat arbitrary or different than what other analysts might deem correct. The 3.33% user in my study is not representative of 3.33% of the market and should not be interpreted as such. The number of issues in each sector is not equal, the market values are different as well, and the economic impact of each sector can also change over time.

These weaknesses are obvious, but I feel they are countered by the strengths. First, having a mechanical trading system using New Highs and New Lows is useful. The charts are useful because they offer a quick reference for spotting changes in a particular group. The charts offer a way of seeing the upside leaders, as well as the downside leaders, more readily than by just the cursory review of the daily New High/New Low list.

Another strength is the aggressive trading results. The results were positive in 11 of the 12 (92%) aggressive trades and beat the S&P 500 in all 12 (100%). The average profit for the total combined aggressive trades was 10.9% versus 2.4% for the S&P 500. The average profit for the 27 trades was 7.7% versus 4.9% for the S&P 500. These returns do not include dividends. The addition of dividends would enhance the returns already mentioned, particularly in the case of the Utilities.

New Highs and New Lows offer internal insight into the markets. Charting them by sector enables us to gain even greater insight. I welcome any suggestions and/or ideas for creating additional parameters for the RSH and the RWL. I am currently working on overbought and oversold ideas, as well as some methods for mathematically combining the RSH and the RWL for generating buy and sell signals.

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