Look past the red and green arrows. From volatility to odd-lot shorts, here are a few indicators pros watch to figure the market's direction
"Sign, sign, everywhere a sign," as otherwise-forgotten '70s rockers Five Man Electrical Band sang in their only U.S. hit. Stocks' recent turbulence has brought another wave of predictions about where the market could be headed (see BusinessWeek, 3/12/07, "What the Market Is Telling Us"). Investors still focused on all the red and green arrows may find themselves feeling, well, a little lost.
Wall Street analysts (and financial journalists) routinely sift through a variety of indicators for hints about stocks' likely next move. Of course, no forecasting tool can be 100% reliable, as anyone who's ever gone outside without an umbrella after reading the weather report could tell you. Still, certain signals help prognosticators make educated guesses about the market—and, like the proverbial broken clock, sometimes even get it right (see BusinessWeek.com, 12/27/06, "Five for the Money's Best Stock Picks").
In an era of Google (GOOG) and other online tools, savvy investors increasingly have access to the same information the pros use. This Five for the Money finds a few indicators investors might want to check for signs of the market's possible direction. Some are commonsensical, others downright wonky, but all are part of the arsenal of Wall Street pros—and worth a look from ordinary investors.
1. The VIX
The Chicago Board Options Exchange Volatility Index (VIX.X) is commonly referred to as the "fear gauge." Some traders use the VIX to measure the implied volatility of Standard & Poor's 500 index options. A drop in the VIX can signal a rise in investors' risk tolerance, while a jump in the VIX could indicate that investor sentiment has grown more cautious.
The VIX moved to historically low levels in recent months, leading some analysts to worry that investors had grown complacent. The index tumbled to a 52-week low of 8.6 on Dec. 18, 2006, down 64% from its June peak. More recently, the market's latest slump has corresponded with a spike in the VIX. On Feb. 27, the index surged as much as 70%, its biggest single-day increase ever, prompting market observers to forecast a bumpy ride for investors (see BusinessWeek.com, 2/28/07, "Stocks' Great Wall of Worry").
2. The TRIN
If "the trend is your friend," as some traders like to say, perhaps the TRIN could be, too. The Arms Short-Term Trading Index, also known as the TRIN, tracks the relationship between the number of stocks increasing or decreasing in price and the volume associated with those stocks. Simply put, the TRIN shows whether volume is moving into advancing stocks or decliners.
If more volume is flowing into advancing stocks, the TRIN will be below 1.0. Conversely, if more volume flows into decliners, the TRIN will be above 1.0. How far the index moves below or above 1.0 dictates how overbought or oversold the market is seen to be. (Analysts use the terms "overbought" and "oversold" to describe when technical indicators suggest stocks are overvalued or undervalued, respectively.)
Amid last week's sell-off, the TRIN reached as high as 8.0 in intraday trading, well into oversold territory. Such a high reading could signal a short-term bottom for stocks, says Chris Johnson, CEO and chief investment strategist of Johnson Research Group. "If everybody's selling in an orderly fashion, it tells you we're probably going to see an extended period of selling," Johnson explains. "You want to see people running out of the theater after someone starts shouting 'fire,' rather than people coming out single-file."
3. Odd-lot shorts
Some market pros gauge investor sentiment by looking at the level of odd-lot short sales, or the amount of bets against the market made in batches of fewer than 100 shares. A spike in odd-lot short interest reputedly shows that average investors, not just the so-called "smart money," are taking a bearish position on the market. This information is released daily by the exchanges.
Because these investors are seen as less sophisticated, traders often use odd-lot short activity as a contrary indicator. Odd-lot short interest surged amid last week's market slide, possibly signaling the rally that followed on Mar. 6.
4. Moving averages
Technical analysts frequently monitor the relationship between major indexes and their moving averages for further indications about possible market direction. Moving averages are calculated by adding the current day's closing price of a security with the like figures for the rest of the days in the average period, and then dividing the total by the number of days in the period. This process is repeated or "moved" each day and a new average is developed.
Comparing the performance of the S&P 500 index against its 50-day exponential moving average may yield some clues for investors. "Almost every individual in the world can now go onto the Internet and pull up a chart and do this for free," says Mark Arbeter, chief technical analyst at S&P Equity Research.
When the S&P 500 is below its 50-day moving average, as it was in afternoon trading Mar. 6, that's typically perceived as a negative sign for the market. Not until the S&P 500 climbs above its 50-day average and the average itself starts to rise again would this indicator become positive for investors, Arbeter observes.
5. Relative strength
Investors who aren't afraid to delve into even more highly technical terrain may be interested in watching the relative strength index, or RSI. This measure is available from nearly any online stock-charting service and can indicate when stocks have touched bottom.
To show a market bottom, the 14-day RSI must fall below 30, which is considered oversold territory. Then, if the S&P 500 rebounds and subsequently suffers a pullback, the RSI must stay above its initial low. "Let's say the market rallies this week up to 1,410," Arbeter explains. "Then the S&P reverses and goes back and tests the low we saw [Mar. 5] and in fact closes below the low of 1,374. You want to see the [RSI] indicator be above yesterday's low."
Once again, none of these indicators can be used with certainty to predict upcoming market action. Still, investors who take them under consideration as one piece of a larger puzzle may find them a handy way of keeping up with the pros.