Chart of the Week – March 28, 2004 - Brett Steenbarger



Chart of the Week – March 28, 2004

Brett N. Steenbarger, Ph.D.



One of the better timing tools that I’ve come across is the one that I’ve dubbed “turbulence”. A turbulent market is one in which stocks are radically shifting relative strength positions over a given period of time. Let’s say we have four stocks that begin the day with relative strength rankings of 1,2,3, and 4, but end the day ranked 4,3,2, and 1. We might say that is a turbulent day compared with a session in which the relative strength rankings remain constant. The way I measure turbulence is by ranking each stock in a universe, computing the sum of the absolute values of the changes in rankings on an hourly basis, and then distilling this number to an index that has a roughly normal distribution. For simpler, but less precise computation, it is possible to use sector indices in place of stocks to assess turbulence.

As a rule, we see greater turbulence prior to and during short-term trend changes than during periods when the market is trending. Indeed, when my Turbulence Index has exceeded 50, it has invariably signaled that some short-term trend change is under way. Below is a chart of the market from 3/10/04 through 3/26/04, with the Turbulence Index in red. Note the short-term trend shifts that accompanied values greater than 50.

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When we take a close look at what is happening during turbulent periods, we can see an interesting phenomenon at work. Stocks with high volatility, which had been leading the way to the downside during a market decline, start to outperform low volatility issues. As a result, a radical swapping of relative strength positions occurs. The stocks that had had the lowest relative strength rankings rapidly move toward the top, while the equities with the highest relative strength ratings quickly descend.

This is an extremely reliable phenomenon.

The very definition of volatility ensures that high beta stocks will outperform lower volatility issues during bullish trends and underperform lower volatility issues during bearish trends. These stocks simply move more than the average stock. This means that there has to be a transition time during which the high volatility issues move from lower to higher as trends shift from bear to bull and vice versa. The Turbulence Index catches these transition times.

Now, if this analysis is correct, we should be able to create an indicator of relative performance that utilizes the turbulence/relative strength rankings to identify periods in which high volatility stocks are outperforming/underperforming low volatility issues. We would expect market tops to be preceded by high readings on this index (indicating relative outperformance by high beta stocks) and market bottoms to be preceded by low readings on the index.

Below is the Relative Performance Oscillator that I have created from the relative strength rankings used in measuring turbulence.

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The Relative Performance Oscillator (RPO) has been calibrated in such a way that values fall between +10 and –10, with extreme readings hitting +7 and –7. A positive reading means that high volatility stocks are outperforming low volatility issues; a negative reading means that low beta stocks are outperforming high beta ones. Note on the right side of the chart (the most recent market action), how the Oscillator peaked ahead of the market decline and then began its ascent as the market was bottoming. When the market has been in decline (oversold) and then the RPO moves above zero, it generally signals that a short-term bottom has been put in place.

These measures—turbulence and relative performance—are a nice illustration of how analyzing market action beneath the surface of the major averages yields information that is useful in trading those averages. I strongly suspect that versions of these measures could be constructed with daily or weekly data for traders looking to capitalize on longer-term market movements. That research project is on the burner.

Brett N. Steenbarger, Ph.D. is Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. He is also an active trader and writes occasional feature articles on market psychology for MSN’s Money site (). The author of The Psychology of Trading (Wiley; January, 2003), Dr. Steenbarger has published over 50 peer-reviewed articles and book chapters on short-term approaches to behavioral change. His new, co-edited book The Art and Science of Brief Therapy (American Psychiatric Press) is due for publication during the first half of 2004. Many of Dr. Steenbarger’s articles and trading strategies are archived on his website, .

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