Market Indicators

ECONOMICS, SENTIMENT, & MOMENTUM

At any given time, there is always a direction that people think the market should be going, will be going, and is going. What a market should do is determined by macroeconomics. By studying the effects of inflation, interest rates, the furrows on Alan Greenspan's forehead, and monetary policy, you can get a good sense of the macroeconomic environment, which will give you some idea of the general health of a company. While it is true that these factors won't make or break a company, they can substantially affect its performance.

For instance, suppose Hank's Steel Mill makes parts for railroads. The Federal Reserve has just announced it is hiking up interest rates significantly, thus tightening the monetary supply. While nothing has happened to railroads specifically, this rise of interest rates discourages J&D's Caboose Co. from expanding its track to a new branch. Because the railroad company has decided to cut investments, Hank's Steel Mill (which makes the parts for the rails) will also lose out. In general, an increase in interest rates deters investment and slows economic growth. Other important monetary indicators are inflation, corporate debt, and consumer debt/spending. Keeping the effects of these external forces in mind can help you predict the state of your sector and security.

What people think a market will do is called market sentiment. Market sentiment is a general consensus of investor expectations; oftentimes, these expectations have not yet materialized in price. Sentiment indicators include odd-lot sales, put/call ratios, ratio of bullish vs. bearish investors, and premiums on stock index futures. These indicators essentially ask the same question: What are certain investors doing and how passionately are they doing it? Whether investors are buying like mad or selling like crazy, their actions can be a good indication of what "the herd" is doing.

But knowing what the herd is doing doesn't mean you must traipse alongside them. Contrarian investors use sentiment indicators to determine majority expectations, and when these indicators have reached an extreme, contrarian investors do the opposite. For example, if the markets are bearish, it means that most investors are selling their holdings. The contrarian investor tries to identify the turning point and starts buying. Similarly, if the markets are bullish, the contrarian investor wants to call the top and start selling shares. Though counterintuitive, the contrarian rationale has been known to be effective. For example, if everyone expects a market to top, there will be no one to push the prices much higher (a resistance level). Likewise, if the market is bottoming, a level of support will keep the price from dropping much further. The contrarian investor will follow the crowd during the trend but will do the opposite at the extreme levels.

Sentiment indicators also rest on the "castles in the air" and "greater fool" theories. In these theories, the course of action is determined by investor expectations, whether or not a security is worth its price. The Internet bubble of the 1990s is a good example of a wildly successful speculative run and the burst that made everything crumble at the end.

Finally, there are momentum indicators. Momentum indicators show what the market is doing. The moving average convergence/divergence (MACD), price/volume indicators, and high/low ratio are all examples of momentum indicators. Momentum indicators gauge market speed and can be used to predict future price movement based on market history. They can also be used to isolate oversold/overbought conditions (perhaps a result of sentiment!). These indicators are useful in generating buy/sell signals.

Figure 1: The 50-week moving average overlaid on the Standard & Poor's 500.

SUMMARY

Used together, market indicators are powerful tools that provide depth and insight into securities and market performance. Even the strongest security can be a risky choice in a weak market sector. But by identifying what a market should do, will do, and is doing through economic, sentiment, and momentum indicators, you can dramatically enhance your trading performance.

Amy Wu is a student at Princeton University.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.