Question:
I am an
avid reader of your blog site and I commend you on the truly great work. You
always identify the bigger picture macro trends and thematics with clarity.
I had a
question if I may in regards to your most recent post on the “weak close
indicator” (link here)
I was
wondering if you could expand on this for me? Are you essentially counting the
number of weak closes over time period (say 200days) and then summing them up
cumulatively? How does the indicator “fall”? IF there is a STRONG close i.e.
close is in the upper 25% of intraday high, does this then lead to a negative
value on the day for the “weak close indicator”?
Answer:
Thanks for the good question and kind words from Down Under.
We have two indicators we use here:
1) Strong Close indicator: if stocks close within 25% of the high for the day, we call it a strong close. We record a +1 and sum the total over the previous 130 trading days (26 weeks).
2) Weak close indicator: if stocks close within 25% of the low for the day, we call it a weak close. We record a +1 and sum the total over the previous 130 trading days (26 weeks).
Let's go through them individually. The first chart is the Strong Close indicator applied to the S&P 500. We show the the last 20 years of our indicator so the reader can get a feel for how it behaves in bull and bear markets. The trend toward fewer strong closes has been evident since last August when the indicator failed to take out the May 2013 high reading of 66. It tested the high again in November and has since come off, currently at 52.
Next is our Weak Close indicator, which is the subject of the original question. Again, we apply the indicator to the S&P 500 over the last 20 years. Here the Weak Close indicator is inverted (left scale, red line). At a current reading of 33, the number of negative closes is increasing and has taken out the the November 2012 high of 32. Generally in equity market corrections/bear markets, strong closes plunge and weak closes spike.
Let's now overlay the change in Federal Reserve total assets to provide some context to why we are seeing a rise in weak closes and drop in strong closes. In the chart below, we invert the Weak Close indicator (blue line, right scale) and compare it to the 3-month change in Fed assets.
There is a pretty strong relationship here that helps illustrate the impact of central bank asset purchases on equity market behavior. If the Fed begins to contract its balance sheet in preparation to begin raising rates, it is likely we see more weak closes. To further this logic and conclude, we show the Weak Close indicator with periods of QE identified in the grey shaded area. For the most past, the experience since the Fed began QE shows how asset purchases bolster stocks. In each phase of QE, from beginning to end, our Weak Close indicator drops. When QE ends, weak closes rise again. We saw this in May-August of 2010, again in June-November 2011. We believe we are seeing this sequence play out again as weak closes have spiked in the months since the taper ended.
