Predict Stock Market Tops and Bottoms With The NH-NL Ratio

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The new high/new low ratio (NH-NL) ratio has been around for many years but different investors use this indicator in different ways. Some investors plot the ratio on a chart using the number zero as a neutral designation with positive numbers equaling more new highs than new lows and a negative number equaling more new lows than new highs based on a specified period of time. I have developed and used the NH-NL ratio in a completely different way from some of the more popular methods. I started to follow stocks making new highs while reading the paper Investor’s Business Daily many years ago. I didn’t use the news highs as an indicator but I only studied stocks to buy from the list. As I became a more experienced investor, I subconsciously started to gauge the market while noting if the new highs were increasing or decreasing. After the stock market bubble burst in 2000, I started to record the difference between the daily new highs and the daily new lows. I would enter them into an excel sheet along with the price and volume of the major market indices and study their relationship. Within two years, I was convinced that the major market tops and bottoms could be located easily by aggressively studying the price and volume of the major indices and studying the ups and downs of the NH-NL ratio. The general market indices often give investors false moves in all directions and many market services and investors have developed new indicators to help assess the market to try and pinpoint turning points without great success. Many of these secondary indicators are successful in showing the investor if the market is weak or strong but they fail to pinpoint the strength or weakness of a turning point with great accuracy. Many of these secondary indicators give false signals along with the general market indices.

With several years of serious study under my belt using my method of the NH-NL ratio, I have accurately protected my money during downturns and have accurately guided my buys when the market has reversed and started a new sustained up-trend (not a head fake).

How do I use my NH-NL ratio?

I start by recording the daily new highs and new lows from Investors Business Daily (my preference) but you could use any free or paid service on the web. Over the past five years, I have developed key levels that the market must reached or violate to trigger certain actions. I am not pulling any of these numbers from thin air as they are all based on actual experience and have not been derived from back testing. For a market to convince me that it is following through and is starting a new up-trend, it must present me with a minimum of 500 new highs per day on a consistent basis. When a week ends, I add the weekly NH-NL totals and divide by the number of active trading days to get the weekly average. The average must have a minimum of 500 stocks per day for me to consider risking over 50% of my cash in new positions (the new leaders). Once the weekly averages reach 800-1,000+ stocks per day, we know that the market is in a full fledged rally and you can start to commit your entire trading stake and use margin. In 2003, the market gave numerous instances when the new highs topped 1,000-1,200 stocks per day, a very impressive amount. When the market shows strength like this, the trend has become obvious and you must have your money working for you by following the trend. Keep in mind that 75% of all listed stocks will follow the general trend of the market.

Recently in September and October of 2005, the NH-NL ratio has been negative, meaning that we are seeing more new lows than new highs. When this type of action happens, you must lock in profits and move your cash to the sidelines. It is not safe to invest on the long side of the market when the ratio is negative. Often times, a bear market may be forming when the ratio weakens and turns negative. If the market confirms a bear market or down-trend, it can be an opportune time to make money shorting stocks or using advanced strategies with options (I only recommend this for advanced and experienced traders). You must determine f the market is in a down-trend or if it is trading sideways. If it is trading sideways, it will be better to pull your cash to the sidelines and wait for a direction to form (either up or down). This article is being written and published on October 25, 2005, the first day after the NH-NL ratio has turned back to the positive side after 13 consecutive days of a negative ratio. The past two weeks have averaged negative ratios with some days only reaching 15 quality new high stocks. This type of weak action could signal a bottom in the market as we get ready to form a new rally. The most crucial indicator to watch over the next few weeks will be the NH-NL ratio to see if it can continue to gain strength and increase the new highs to 500 or more stocks per day. If this happens, the current indication that a rally has formed on the major indices will be confirmed and you can start to commit more than 50% of your trading stake to new leaders breaking out of sound bases or stocks moving higher from establish support areas.

As I look back at my archived hard copies of IBD, I can see the strength and weakness that this ratio gave us throughout 2002 and 2003. I am reminded how the ratio went from negative territory in September of 2002 to a positive ratio in October of 2002. After reaching positive territory, the new high ratio soared into the 800-1,100 range in the first six months of 2003 as we were in a strong bull market, the strongest year since the bubble burst. I don’t know what next month or next year holds for investors, but you can get a good idea by tracking this indicator as it turns back to the positive side after a very poor October (2005). I once wrote about the Halloween indicator and I am now convinced that it has some validity, especially if this NH-NL ratio confirms another rally as October draws to a close.

Chris Perruna