chart: McClellan's Proportional Price Oscillator

Courtesy of McClellan Financial Publications

Comments by JustSignals
With the addition of the yellow highlights and the red & green trend lines you can make certain assumptions.  Since 2008 there were four times this chart was oversold.  In 3 of the 4 times the market tested the lows.  When the lows were tested the PPO made a higher low.  This positive divergence was constructive and a good buy indicator.  The problem is that this type of pattern is not necessary, but, it is likely based "only" on probability.

Excerpts from the article written by Tom McClellan

Generally speaking, when the Price Oscillator is rising, that is bullish, and when it is falling that is bearish.  The positive and negative implications gain greater weight when the Price Oscillator is positive or negative.  In other words, a negative and falling Price Oscillator is more negative than if the Price Oscillator were falling while above zero.

When the Price Oscillator reaches extreme readings, those rules start to change, just as a bungee jumper experiences different types of acceleration or deceleration as the bungee cords reach their full extreme.  But the raw math of the calculation of the Price Oscillator contains one slight problem which makes identifying extreme values more difficult: the amplitudes increase as prices go higher.

Over short time periods, that is not so much of a problem.  But if we want to do a really long term comparison of Price Oscillator values, then it is best to add one more bit of math to the equation, and create what we call the Proportional Price Oscillator or PPO.  Its calculation involves taking the regular Price Oscillator (10%T minus 5%T) and then dividing it by each day’s closing price. 

The chart above shows the PPO for the DJIA, dating back to 2008.  The rapid price drop in August 2015 has already created a pretty oversold reading for this indicator, the equivalent of what we saw in 2011 after the end of QE2, and of the low in 2010 following the post-QE1 Flash Crash and its ensuing aftermath.  So on that basis, an argument can be made that enough damage has been done to stock prices, and that we should be looking upward from here.

But that argument presumes that the stock market is still in a very long term uptrend, and so that uptrend rules for oversold conditions still apply.  But when we look back at how the market behaved in the 2008 bear market, we find that different rules of interpretation must be applied.

During the 2008 bear market, we saw much lower readings for the DJIA’s PPO.  So yes, Virginia, the market really can get more oversold than this.  In a bear market, the oversold readings only lead to temporary pauses in the decline, and then more downward movement ensues.  So before one can properly interpret the current oversold reading in the PPO (or any other indicator), one must first determine one’s assumptions about whether this is really a bear market, or just a “correction”. 

If you are not ready to make that determination for yourself, then the Price Oscillator can help.  It can reveal to us, with a lag, that a supposed bull market bounce is failing when it turns back downward while still below zero.  Notice how that happened several times during the 2008 bear market.  Each time a Price Oscillator turns down while still below zero, it conveys the “promise” of a lower closing low on the ensuing move.  Please note that “promise” is not the same thing as “guarantee”.  The promise of a lower closing low can be revoked if prices turn back up again promptly. 

Use the following link to read the full article
http://bit.ly/1XFXwEV

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This has been posted for Educational Purposes Only.   Do your own work and consult with Professionals before making any investment decisions.  
Past performance is not indicative of future results