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June 27, 2003

Trading the NYSE BPI
by Adam Hamilton

One of the primary reasons I so much enjoy studying the markets and speculating is the thrill and satisfaction of constantly learning. Even though the grand strategic forces like valuation and sentiment that ultimately drive the markets never really change, there are always opportunities to embark upon fresh avenues of analysis on current market conditions.

In an intriguing twist of fate, one classical methodology of technical analysis, a paradigm through which to view the markets, is resurging in popularity these days. It is called Point-and-Figure Charting (P&F) and is offering a new perspective to many stock operators including me.

P&F analysis has been around for a century or so. It is a method of charting that focuses solely on price movements of a predefined magnitude graphed across an undefined time scale. Even if you are not familiar with P&F charting you have probably seen the distinctive and unmistakable P&F charts, which are built with columns of X's and O's.

P&F charting was originally developed in the early 20th century partially because it allowed a technical analyst to easily maintain many dozens of charts by hand daily. Today in the Information Age we take for granted how easy it is to build charts since computers now do it for us in a fraction of a second, but manually plotting and connecting each data point with pencil and paper was quite a tedious undertaking.

The popularity of P&F charting began to fade in the early Computer Age when the tedium of constructing conventional charts was eliminated by the machines. Yet, somewhat paradoxically, today in the Information Age with ubiquitous computers and data P&F analysis is making a strong comeback. The P&F charts have many advantages that conventional price charts with fixed time scales cannot match.

P&F charts generally have much higher signal-to-noise ratios than conventional charts, as they ignore small price movements. Technical analysis done on P&F charts can be far clearer than conventional charts for several reasons.

First, defining trendlines on P&F charts is very easy since all trendlines, due to the construction methodology of P&F, always occur at 45-degree angles. Second, support and resistance lines are exactly horizontal, removing much conventional charting ambiguity on these key price levels. Finally, P&F ignores temporal distortions created by the variable passage of time between important price movements and focuses exclusively on price alone. This methodology helps zero in on underlying supply and demand, the ultimate drivers of future prices.

I have been aware of P&F charting for a long time now and it has long danced at the periphery of my market perceptions. While I am still a green neophyte in terms of my feeble level of P&F analysis knowledge, I am looking forward to studying the arcane P&F arts in the coming years to augment my overall understanding of the markets and speculation.

If you too are interested in P&F charting, there is one book in particular that everyone I know who is involved in P&F analysis highly recommends. It is called "Point and Figure Charting" by Thomas Dorsey and is easily available on Amazon.com. Unfortunately I haven't found the time to read this book myself yet, but I am really excited to learn from Mr. Dorsey's great wisdom and his book is high on my summer reading list.

My essay this week isn't about P&F charting in general, but about some really unique tools P&F speculators have developed called the Bullish Percent Indices (BPIs). A BPI is a measurement that defines the percent of stocks in a given index or sector that are currently exhibiting P&F buy signals. For example, if 300 of the 500 stocks in the flagship S&P 500 index were exhibiting P&F buy signals, the S&P 500 BPI would read 60%.

P&F BPIs are maintained for many major indices including the S&P 500, S&P 100, Dow 30, NASDAQ, and NASDAQ 100. The mighty patriarch of the BPI world, however, is the venerable NYSE BPI. It documents what percentage of stocks in the entire universe of companies that trade on the New York Stock Exchange that are exhibiting P&F buy signals on any given trading day.

The NYSE BPI was created in 1955 by celebrated Chartcraft analyst A.W. Cohen, the same market genius responsible for the famed Investors Intelligence Sentiment Survey. Mr. Cohen built on the earlier work from the 1940s of an analyst named Earnest Staby who wanted a good contrarian indicator that would be bullish at market bottoms and bearish at market tops, just the opposite of conventional price charts.

For the past half-century or so, gifted financial analysts like A.W. Cohen and Thomas Dorsey have refined the study of the NYSE BPI into an art form. With such an impressive pedigree and ancient track record by contrarian-indicator standards, I have started delving into the NYSE BPI myself in recent months. We just posted some long-term charts of the NYSE BPI graphed under the S&P 500 going back to 1966 at www.zealllc.com/charts/bpinyse.htm if you are interested.

The primary impetus for these P&F BPI studies for me was the traumatic war rally in stocks, which oddly defied powerful sentiment indicators like the VIX and PCR and crushed the shorts. While pure sentiment speculators like myself who throw short on extreme greed alone were blasted by the war rally, the P&F traders watching the BPIs were among the minority of contrarian players who saw the writing on the wall early and recognized the war rally well before it wreaked havoc on most short-side operators.

Our first graph this week shows the daily NYSE BPI graphed under the benchmark S&P 500 stock index. The powerful contrarian nature of the BPIs is very apparent in this graph. High BPIs signal too much greed, the time to short, while low BPIs signal too much fear, the time to go long. The whole contrarian philosophy inherent in the P&F BPI design dovetails beautifully with contrarian speculation based on general market sentiment.

For this first graph we followed the P&F gurus' lead in defining NYSE BPI highs over 70% and lows under 30% as extreme and looked at the short-term S&P 500 performance after each of these events. Each extreme NYSE BPI reading is accompanied by the actual BPI peak or trough in red and short-term S&P 500 performance following these events in blue. The top blue number is the 10-day S&P 500 performance and the bottom number the 20-day following NYSE BPI extremes.

As you can see both in the late 1990s Great Bull and the early 2000s Great Bear markets the powerful contrarian nature of the NYSE BPI as an indicator is readily apparent. A reading above 70% on the NYSE BPI only occurs near interim tops when the markets are on the verge of a pullback or downleg at worst and sideways trading at best. Speculators should watch for these stellar NYSE BPI readings above 70% and close longs and consider deploying shorts when they develop.

In the 4 major NYSE BPI tops above 70% in the past six and a half years the average 10-day and 20-day S&P 500 returns following these events were -2.0% and -2.3% respectively. Speculators will also note that today the NYSE BPI is once again in this >70% topping range these days, suggesting that the powerful bear-market rally in the US stock indices since mid-March is probably over.

In terms of extreme NYSE BPI lows, this P&F BPI provides even better signals for contrarian speculators to throw long in the face of great popular fear. Of the 5 major NYSE BPI bottoms under 30% in the past six and a half years the average 10-day and 20-day S&P 500 returns following these events were +7.6% and +10.6%! Needless to say, these are enormous moves in a major stock index in such a short period of time. Leveraged with call options, speculators could have realized fantastic profits going long fear at these major NYSE BPI lows.

While this quick strategic overview of the NYSE BPI relative to recent stock-market performance is encouraging, it doesn't address the great challenge of real-time analysis. Sure, it is easy to look at historical graphs to define highs and lows in any price with perfect 20/20 hindsight. But the real game is to call these highs and lows soon enough in real-time to be able to immediately profitably trade on them. Is today's >70% NYSE BPI reading the top or not?

Naturally, the great P&F gurus who have been studying the BPIs in relation to index speculation for a half century have a solution. Rather than trading right on what may later prove to be a major high or low a conservative alternate strategy is employed, patiently waiting for a reversal in the BPIs as a confirmation of a BPI trading signal before any trend change is assumed.

The most common BPI reversal I have seen used in the P&F BPI lore is 6%. This means that once a BPI reverses more than 6% from its latest major interim high or low it is considered a technical signal to actually deploy contrarian speculations. For example, if the NYSE BPI reaches 71% and then slides back down through 65%, a 6% reversal, then P&F speculators consider a speculation signal to have been flashed and promptly deploy their contrarian trades.

Our next graph zooms in to the recent Great Bear years and analyzes these NYSE BPI reversals and their signals relative to the S&P 500. While this chart does look unduly complicated, the idea behind it is simple.

Each yellow arrowhead defines a 6% reversal in the NYSE BPI. A down arrow signals a reversal down, a shorting signal, while an up arrow signals a reversal up, a long signal. S&P performance between each BPI reversal is documented with three pieces of data including the BPI level at which the reversal occurred in red, the actual S&P 500 gain or loss over the period of time between the previous and current reversal in blue, and the trading days between each pair of sequential reversals in white.

In addition, green or red lights next to each reversal document whether a speculator would have won or lost by trading on the immediately preceding reversal. For example, if a 6% BPI reversal down indicated a shorting opportunity, the subsequent reversal records whether or not that was indeed the right trade to make. A green light indicates the immediate prior reversal signal was correct and a red light indicates it was not.

Of the 18 NYSE BPI 6% reversals shown below, 7 gave the correct trading signal leading into the subsequent reversal while 11 did not. Initially these results surprised me, as I expected the 6% NYSE BPI reversals to give superior signals, but upon closer analysis it made more sense.

This chart presents the raw reversal-to-reversal performance in S&P 500 terms of trading on NYSE BPI 6% reversals. The average gain in the 7 successful BPI reversal signals, the green lights above, ran 6.0% reversal to reversal. The average loss in the 11 unsuccessful BPI reversal signals, the red lights above, averaged 5.4%. The obvious conclusion to draw is that directly trading the S&P 500 from NYSE BPI 6% reversal to 6% reversal is not an optimum contrarian speculation strategy!

Of course the P&F gurus don't exclusively trade reversal to reversal. They have refined the art of trading the BPIs with some basic rules that eliminate most of the red trades above and capitalize on the green ones. Before we delve farther into that however, it is useful to examine the reversal-to-reversal graph above in order to gain some insight into the advantages and disadvantages of using the BPIs as contrarian speculation tools.

On the advantage side of the ledger, waiting for 6% BPI reversals helps speculators prudently catch emerging trends already in progress. It is always risky trying to anticipate an interim index top or bottom as it is happening, and the BPI reversals minimize this risky endeavor by helping speculators to not jump the gun by patiently waiting until early signs emerge that a short-term trend change has actually developed.

But, a BPI disadvantage emerges from this same BPI lag inherent in waiting for a 6% reversal. BPIs are built solely on pure technical stock-price action, so they can't anticipate trend changes. Trading on BPI reversals alone it would be impossible to trade at exact tops and bottoms since each interim top or bottom would already be past by the time the full 6% BPI reversal emerged on the charts.

This BPI lag is evident in the graph above. You will note that many of the green lights are clustered around major market moves developing over multi-month time frames, where the delayed entries and exits while waiting for a BPI reversal are not as important. In contrast, many of the red-lighted trades emerged when the markets were bouncing around rather rapidly, rising and falling over condensed multi-week time frames where trading delays waiting for the 6% reversals were comparatively much more costly.

You will also note that the BPI reversals tended to be most powerful as indicators near extremes. Reversals emerging from the >70% and <30% regions of the BPI chart generally led to far better reversal trades than reversals in the chaotic central region of the chart.

Of course the P&F BPI gurus already know this so they also shoot for the extreme reversals above 70% and below 30% as trading signals rather than worrying about all the mid-chart reversals. Our next graph builds on this approach, with a yellow-highlighted center zone where BPI reversals are not used as trading signals. In this chart iteration, the blue numbers beside the yellow reversal arrows represent the S&P 500 daily close when each reversal occurred.

The elite P&F gurus like Mr. Dorsey often describe the BPIs in the context of an excellent football-game analogy. The middle of the BPI charts between 70% and 30% is like a football field while the extreme levels outside this range are like the end zones where touchdowns are scored. The current track of the BPI is described as showing whether offense or defense has the ball, whether the short-term trend is bullish or bearish, to help speculators make the right trading decisions in real-time.

As the BPI bounces around in the middle of the chart, as it did in much of 2000 and also in late 2002/early 2003, it indicates that the longs and shorts are pretty much stalemated for the time being and the markets are probably essentially trending sideways.

But when the bulls grab the ball and sprint to the upside out of the yellow center zone or the bears grab the ball and head south out of the yellow center zone, it is time for traders to respect the in-progress play and either quickly reposition their capital to run with the prevailing momentum or step out of the way until an extreme reversal happens. The BPIs help keep speculators from fighting the short-term trend like the sentiment traders fought the war rally.

One of the reasons the P&F operators didn't hemorrhage as much speculative capital in the recent bear-market rally as the pure sentiment traders was because the BPIs reversed and headed higher as the war rally launched. Even if the BPI advance was ignored until it got out of the neutral center zone, it still warned P&F speculators before the S&P 500 neckline fell that the bulls had the momentum so the markets would probably head even higher.

By understanding some of the P&F BPI trading theories, speculators schooled in P&F methodology knew to throw long and run with the bulls, regardless of sentiment and fundamental extremes, by early May at the latest (near the S&P 500 at 920 or so). Only when the bull run demonstrably ends, when the next 6% BPI reversal from above 70% occurs, will P&F BPI theory strongly consider shorting again.

Understanding the bullish and bearish momentum evident in the P&F BPIs enabled P&F-grounded speculators to avoid getting crushed in the odd war rally like the pure sentiment traders did, including yours truly. Watching for these extreme BPI levels above 70% and below 30% and then waiting for a 6% reversal to signal a major short-term trend change is an extremely important discipline to develop for all index speculators!

In the graph above the top shorting signals off high BPI 6% reversals are very good and I am currently eagerly awaiting the next one, but the bottom long signals are far too slow for my tastes due to the inherent lag in the BPIs. As you can see above, the V-bounces marking major interim lows happen lightning fast while the interim tops tend to be slow grinding affairs with lots of time to wait for a 6% BPI reversal.

Believe it or not, often about 50% of the entire gains of most major bear-market rallies are won within the first 10 trading days after a V-bounce, so there is a huge incentive to try and pick the bottoms before waiting for a 6% P&F reversal to develop. As such, I still prefer the VIX and Relative VIX as oversold V-bounce long indicators rather than P&F BPI reversals. All the V-bounces labeled above are marked at high VIX readings, not BPI reversals.

Unlike the P&F BPI reversals which take time to develop, VIX extremes are apparent the hour they happen and can help alert speculators to a potential V-bounce at least several days before the P&F BPIs catch up and reflect the trend change. The graph above shows the S&P 500 entries and exits achievable using high P&F 6% reversals as primary shorting signals and high VIX extremes as primary long signals. This system has been very profitable in this Great Bear to date.

As this superficial initial look at the NYSE BPI illustrated, the BPI-reversal concept itself can be very valuable for index speculators to monitor. The P&F gurus have long known this, but in my experience the majority of sentiment speculators don't track the BPIs. I believe they probably should.

At Zeal we are actively tracking the various major BPIs daily and eagerly awaiting the next major short-signal reversal in the indices in both our monthly Zeal Intelligence and anytime Zeal Speculator newsletters for our subscribers. Odds are the next major 6% reversal will effectively signal the death knell for the powerful bear-market rally we have witnessed in recent months. You speculators not afraid of playing the short side don't want to miss this huge potential opportunity!

In the markets lately the bulls have had the ball and ran it in for a touchdown, but it looks like finally now the bears are preparing to storm the field and raise some havoc again. It's payback time for the bulls!

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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