Body Language
What market internals are telling you

I’m a big believer in what I like to call the “body language” of the market. Like you, I’ve grown up in my investing career watching CNBC, attending investment seminars and listening to the “guru’s” spewing their prognostications. I’m not here to tell you that you shouldn’t use quality research and I certainly don’t think you need to forsake outside opinions all together. However, I am telling you that if you distance yourself from the daily noise and truly focus yourself on what the market’s telling you, you’ll be a much more effective trader and I have a few tools that will help you do that.

Most of the early technical forefathers will tell you that the two most important factors in analyzing a stock are price and volume. I agree with their sentiment but also feel that if you’re able to add in a few quality confirmatory indicators to verify what the chart is telling you, you’ll be a much more effective trader. Let’s run through a few of my “body language” indicators:

1. The Advance/Decline Line – The Advance/Decline line (or AD Line) is an indicator I use to gauge the strength of the overall markets internals. As we’ve discussed before, you never want to trade against the overall trend of the market. Thus, the first thing you should do is verify that the internals are backing the price action for the overall market condition.

Each trading day, the exchange and over-the-counter marketplaces publish statistics on how many of their issues closed higher and how many closed lower. The day’s advance-decline for any market (although I typically focus on the NYSE) is simply the difference between these two numbers. For example, if 1200 issues advanced and 300 declined, the day’s net number would be 900. If 300 advanced and 1200 declined, the number would be –900. Each day’s net number is then added to a running total and the result is plotted in a chart. The bottom line for the indicator is that if market prices are rising, we should be seeing the advancing issues outnumbering the declining issues. This defines a healthy market. If prices are moving higher but decliners are outnumbering advancers on a consistent basis, it’s an unhealthy market and liable to reverse. Most of the time, the advance-decline line and the price of the representative market index move higher and lower together. It makes sense that in rising markets, the majority of stocks should be rising themselves. Conversely, in falling markets, the majority of stocks should be falling. One of the most valuable signals you’ll get from this indicator is by any divergence that emerges from price action. For example, if the equity markets are hitting fresh 52-week highs and the AD Line is falling, this is a negative divergence and it’s a market you’d most likely be setting up to go short in.

Take a look at the example below to see what the AD Line looks like. The two bar charts at the top are for the Dow Jones 30 and the S&P 500. The smoothed blue line at the bottom is the AD Line for the NYSE. If you look at the chart for the NYSE, you’ll see I’ve drawn a resistance line on the chart. I’ve drawn the same resistance line on the AD Line chart. The most important thing you’d take from the AD Line in this instance is that it broke through a key resistance zone and hit new highs far before the actual price break in the broader markets. Thus, the indicator was confirming (and actually preceding) the price action in the broader market. This was a very buyable breakout.

Except under extraordinary conditions, the stock market does not turn around instantly. Typically, markets turn more slowly and more in tune with established business and market cycles. At the end of a bull market, the advance-decline line can roll over and even head lower well before the market indices do. This divergence provides the signal that all is not well and that the market health has deteriorated.

2. On-Balance Volume – On-Balance Volume (OBV) is one of the best confirmatory indicators for individual stocks in the entire market. It was developed by Joseph Granville in 1963 and revealed inside the pages of his book, Granville’s New Key to Stock Market Profits.

OBV is a momentum indicator that measures positive and negative volume flow. In reading the theories surrounding OBV, it’s apparent that Granville felt volume to be the driving force behind the markets. The indicator was designed to project when major moves in stocks and markets would occur and described the increase or decrease of his indicator, setting new highs or lows, as “a tightly wound spring”. He went on to explain his theory by stating that when volume increased or decreased dramatically and the underlying issue’s price did not change significantly, then at some point the price would shoot upward or downward. Now, something very interesting comes out of this theory that seems to have a lot of merit. It appears that as the institutions begin to buy into an issue that the retail investors are still selling, the volume is increasing, as the price is still slightly falling or leveling out. Over a period of time the volume begins to drive the price upward and the converse then begins to take over as the institutions begin to sell their position as the retail investors begin to accumulate their positions again. Thus, the term ‘smart money’ begins to appear crystal clear, understanding that the institutions are buying the stock of the average investor at the bottom and then selling it back to him at or near the top. You can also see how the OBV indicator can suggest major trend line turnarounds.

Let’s take a look at a quick example of how OBV can give you an early signal as to the next price direction for an issue. The chart below is of one of the high beta Internet movers UTStarcom Inc (UTSI). As you can see from the chart, UTSI had been on a huge move to the upside. To this point (first chart), the stock had been a fluid series of higher highs and higher lows. As well, the OBV (blue line at bottom) had been confirming each of the peeks. Every time UTSI hit a fresh high, the OBV hit a fresh high. However, at the last peek something changed. The body language of UTSI, through OBV, changed. The indicator did not confirm the last high the stock hit and if you look at the second chart, you’ll see the effects. UTSI proceeded to take a 25% haircut.

The basic assumption, regarding OBV analysis, is that OBV changes precede price changes. The theory is that smart money can be seen flowing into or out of a security by a rising or falling OBV. When the public then moves into the security, both the security and the OBV will surge ahead. If the security's price movement precedes OBV movement, a "non-confirmation" has occurred and investors should proceed with caution.

3. Relative Strength Index – In a broad-based rally, most stocks are advancing. However, as traders, our investment dollars only deserve the “best of the best”. When talking about defining these “best” issues, few indicators work better than the Relative Strength Index (RSI). The RSI is a comparison between the days that a stock finishes up against the days it finishes down. It’s a reasonably simple model that anyone can use and most software packages provide it for you as an indicator.

The RSI ranges from 0 to 100. A stock is considered overbought above or around the 70 level. The number is not written in stone and in a bull run some believe that 80 is a better level to indicate an overbought stock since stocks often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30 a stock is considered oversold and you should consider buying. Again, make the adjustment to 20 in a bear market as most stocks tend to get significantly oversold. As well, as with many indicators, trend lines form on the RSI line itself that can be used to determine the “direction of the strength” for the issue.

Take a look at the two charts below. They’re for a high beta Internet E-Commerce issue called Interactivecorp – (IACI). In the first chart, you can see that IACI was in a beautiful up-trend. The trend was characterized by a strong series of higher highs and higher lows. However, take a look at the RSI line below the chart. It was telling you that IACI was on its last leg and its performance was actually lagging the overall market. In other words, the RSI line was telling you that IACI was losing steam against the broader market. If you look below, you can see the downtrend in the RSI line that proceeded chart number two. Much like the UTSI we saw above in the OBV section, IACI took about a 20+% haircut when it began to fall apart. Again, this is an issue whose trend changed gradually and the RSI was an early warning signal as to the internal break down of the stock long before the actual price broke lower.

Price and volume are by far the most important aspects in the analysis of stocks. However, savvy investors can gain an advantage to the markets by simply “reading between the lines” on some of the market and stock internals. As investors, we’re constantly influenced by news stories, analyst opinions and our own biases. But, if you’re able to distance yourself from the noise and take an unbiased look at the body language of stocks and markets, you’ll find yourself making unemotional and justified decisions that will inevitably make you a stronger trader.