MCCLELLAN SUMMATION INDEX IS A LONG-TERM BREATH MOMENTUM INDICATOR THAT HAS REACHED A TWO-YEAR HIGH -- WHY THE MARKET COULD BE FORMING A BULLISH HEAD AND SHOULDERS BOTTOM

MCCLELLAN OSCILLATOR IS STILL POSITIVE ... The McClellan Oscillator is a short- to intermediate-term momentum breadth indicator. It's calculated each day by taking the difference between the 39-day and 19-day exponential moving averages of the number of net advances on the NYSE (see Chart School for a more in-depth explanation). Chart 1 shows the NYMO (black line) compared to the NYSE Composite Index (green line). The McClellan Oscillator fluctuates between an oversold level below -100 and overbought territory above 100. Short-term buy and sell signals are given when it crosses above or below its zero (flat) line. Chart 1 shows, for example, the NYMO bouncing from oversold territory in late February before crossing over its zero line in early March (circle). Although it has backed off from overbought territory at 100, it remains above its zero line. It would have to fall below that line to signal an end to the rally. The McClellan Oscillator is only useful over the short to intermediate term. In my view, its greater value lies in its longer-range version which is called the Summation Index.

Chart 1

SUMMATION INDEX REACHES TWO-YEAR HIGH ... The Summation Index (NYSI) is the longer-range version of the McClellan Oscillator. Its daily values are determined by adding or subtracting the Oscillator values each day. A negative Oscillator produces a lower Summation Index. A positive Oscillator produces a higher SI. The Summation Index also fluctuates around a zero line. In my view, however, its real value lies in telling us the long-term direction of breadth momentum. [Since this is a momentum indicator, it doesn't resemble the traditional NYSE Advance-Decline line. Momentum indicators usually change direction first]. Chart 2 compares the Summation Index (black line) to the NYSE Composite Index (green line) over the last three years. You'll notice, for example, that the SI started dropping during the spring of 2007 (red line) which gave early warning of the stock market peak. Now for the good news. After bottoming during October, the SI rallied to a January high before falling back again. The good news is that the March bottom formed above the October low which formed the type of "positive divergence" that we've seen in several other long-term momentum indicators (black line). Chart 2 shows that the Summation Index has now exceeded its January peak and has risen to the higher level in two years (circle). It's now higher than when the bear market started. I take that as further evidence that the stock market is forming a major bottom.

Chart 2

COMPARISON OF BREADTH MEASURES ... To show visually how the Summation Index tends to lead turns in the NYSE Advance-Decline line, I've included both in Chart 3. You can see that the SI (black line) is more volatile than the NYAD (blue line) and changes direction first (in both directions). The SI turned down first during 2007 and has turned up first during 2009. While the upside breakout in the Summation Index is encouraging for the market, it would be even better to see some upside confirmation by the NYAD line as well.

Chart 3

NYAD LINE TESTS 200-DAY LINE ... The NYSE Advance-Decline line usually leads turns in the broader market. During the last half of 2007, for example, the NYAD line formed a lower top and failed to confirm the market's move to new high ground. That was an early warning of a market top. Its drop below the 200-day moving average in the fourth quarter of that year was further warning of a bear market. Chart 4 shows the NYAD (blue line) hitting a new low during March along with the NYSE Composite Index (dashed line). What's worth noting in Chart 4 is that the NYAD is challenging its 200-day average (red line) and its January high. That will be an important test for the market as a whole. A close above that resistance would certainly be a positive sign for the market. A pullback from there, however, wouldn't be so bad either.

Chart 4

HEAD AND SHOULDERS BOTTOM IN THE MAKING?... Chart 5 shows the NYSE Composite Index moving up to challenge its late February peak near 5500. A decisive close over that barrier would increase the odds for a further rally toward its January high near 6000. That would bring it into play with its 200-day average as well (the same is true with the Dow and the S&P 500). A pullback from that resistance region would then be likely. Here's a possible scenario from there based on the pattern since November. Notice that the March low is lower than the November low. That raises the possibility of a "head and shoulders" bottom in the making (with the November low the "left shoulder" and the March bottom the "head"). If that is correct, the flat trendline drawn over the January high would be a "neckline". A pullback from that line would pave the way for a "right shoulder" which is the final part of the bottoming pattern. There's usually a certain symmetry in a H&S bottom. A subsequent "right shoulder" from the area around the January high could retrace a half to two-thirds of the rally off the March low (or to the area around the November low). A right shoulder in a "head and shoulders" bottom usually represents a great buying opportunity.

Chart 5