The Highs & Lows of Cinco de Mayo

Perhaps it was the tequila, but on Monday, May 5 -- Cinco de Mayo -- there was an interesting series of three posts on the use of the SPX High-Low Index to help time the market. I use this indicator as well, and three posts in one day caught my eye. What struck me is that I apply the SPX High-Low across a slightly different timeframe, and so am adding a fourth post to the discussion.

-- Bill Luby at VIX and More smoothes the High-Low Index with a 20-day EMA to identify intermediate oversold levels and changes in trend. It's a solid approach, a good article, and is one that makes similar observations to my own.

-- Babak at Trader's Narrative uses an intermediate time frame as well, but smoothes with a 10-day MA. Babak posted on the SPX High-Low Index because for him the indicator is currently suggesting caution. While it's not flashing an extreme, Babak senses that the index is nearing an overbought condition. "The easy money has been made in [the SPX] trade."

-- At Investor Village, in a response to Bill Luby, pcyhuang offers an alternative interpretation. It takes the daily readings of the SPX High-Low and applies Parabolic SAR. Since the daily High-Low data are extremely volatile, pcyhuang's version is very jumpy. With unsmoothed, daily SAR settings, this version of the indicator favors short, 3-14 day time frames.

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I found these posts interesting because I discovered the accuracy of High-Low as a Buy/Sell indicator resides more in longer time-frames. In other words, I'd been burned over the years by applying short and intermediate time frames, and found accuracy only after tweaking the time frame longer.

The chart below reveals how a 10-week EMA of the SPX High-Low Index is useful in identifying key, cyclical changes in market trend. The biggest caveat is that High-Low is at its best in picking bottoms, and is dicey at picking tops. At indicator tops, stocks can rally on for months, even as the indicator throws off multiple sell signals. However, extremely low readings provide decent bottom calls.

Over the 6-year period below, the 10-week EMA oscillates in a channel between 50 and 90. You can see that extremely high readings generated numerous false sell signals ( a cross below 90). However, extreme low readings marked both the 2002 and (potentially) 2008 bottom. Crossovers above 50 trigger a cyclical buy.

The takeaway is that the SPX High-Low Index below is currently triggering an important cyclical buy signal for the market, but it remains unconfirmed.

OK now pass the guacamole.

best

dk