Our new highs/new lows indicator simply takes the total number of stocks hitting new 52-week highs (on the Nasdaq and New York Stock Exchange combined) and divides this by the number of all equities hitting new lows and new highs. When studied on a day-over-day basis, this indicator offers a view of the underlying breadth of the market. Many traders believe this is best used as a confirming indicator in conjunction with other market-timing tools from the technical and/or sentiment families of indicators.
Our use of breadth indicators such as the new highs/new lows ratio is shorter term and ultimately more quantitative than the research of traditional technical analysts. We have found that the daily count of new highs and new lows can be formulated into a very effective oscillating indicator of overbought and oversold conditions. Looking at a 10-day moving average of this data helps smooth the data and define any trend that might be forming.
In our view, a bullish signal is defined as a period in which the 10-day moving average of the new high/new lows ratio first slips below 25% (indicating a strongly oversold condition, where just one-quarter of all stocks hitting new highs or new lows are achieving the former) and then makes 2 subsequent upticks (suggesting an end to the decline and an imminent reversal).
Before the indicator recovers back to 70%, which is approximately equal to the historical average, the bullish signal turns off temporarily after 2 downticks in the 10-day moving average. It returns to bullish on 2 upticks. After moving back above 70%, 2 downticks shuts off the signal permanently (until the next move back below 25%).
Since 1990, this bullish situation has occurred about less than one-fifth of the time. But during these periods, the S&P 100 Index has shown an average gain that is notably higher than its at-any-time daily move. While it is possible for this highs/lows bullish signal to shut down quickly on market weakness, similar oversold levels in recent history have typically reversed in due course, triggering long and sustained market rallies.