Generals Are Marching but Soldiers Are Deserting

Apurva Sheth

Baahubali is the best movie franchise the Indian film industry has ever produced. The two-part movie is a visual extravaganza. I loved both parts - The Beginning and The Conclusion. But one moment from the first part stands out.

An army of savages known as the Kalkeyas attack the Mahishmati kingdom. The Mahishmati army is led by Amarendra and Bhallaladeva.

Though small, the Mahishmati army gives a tough fight to the Kalkeyas. However, at one point, the Kalkeyas take charge and frighten them off with their gruesome killing.

Just when it seems that Mahishmati would be defeated, Amarendra inspires his soldiers to fight back and they end up crushing the enemy.

In war, generals can't march alone and expect to win. Amarendra knew he needed his soldiers to bring the enemy to their knees.

What if he had gone alone to fight the Kalkeya king? Would he have succeeded?

Well, perhaps in a movie one man could kill a whole army. But what about real life? Would the results be same?

No, of course not.

In a real war, generals marching forward while the soldiers desert would be a prelude to disaster.

In the stock market, it's much the same.

Let's say the stock market is a battle between two armies - the green army (bulls) and the red army (bears). The aim of green army is to move northwards. The red army wants to resist their advance and move southwards.

The generals of the green army are the mid and large-cap heavyweights that drive the Nifty and Sensex. The soldiers of the green army are the mid and small-cap stocks that do not find a place in the benchmark indices but still participate in the war.

Generally, the more soldiers participating in a northward march, the stronger the army. Similarly, a market uptrend is considered strong when a large number of stocks from the broader markets hits new highs.

Now, let me show you how the markets are currently marching. This chart depicts stocks hitting new 52-week highs and lows.

Broader Market Participation
Broader Market Participation

The black line is the Nifty Index. The green bars are the number of broader market stocks hitting new highs while the red bars are the number of stocks hitting new lows on a particular day.

As you can see, the Nifty has been moving higher since December 2016. Participation from the broader market stocks also increased consistently until April 2017. On 5 April, the Nifty touched a new high of 9,273, and on the same day, 189 stocks listed on the NSE hit a new high. This was highest participation in more than two and half years.

However, over the past two months, the participation of the broader market stocks has fallen significantly. In other words, the generals (large caps) have been leading the rally. Meanwhile, the soldiers of the green army (mid and small caps) have been deserting the battlefield.

On 24 May, the red army significantly outnumbered the green army with 81 stocks hitting new 52-week lows.

The retreat of the green soldiers should be a warning signal to the bulls. They need to inspire their soldiers quickly just like Amarendra, for the generals can't march alone.

Until that happens, the fate of the green kingdom is on very shaky ground.

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Market Notes

How to Quadruple Your Returns with the AD Ratio Signal

In our previous market note, we showed you how a simple indicator can pick market bottoms. The indicator is called the advance-decline (AD) ratio. We backtested this indicator over seventeen years of Nifty history. And the results are amazing.

More on that in a minute...

First, we want show you how this market breadth indicator works and how the signal it gives can reveal market bottoms and generate extraordinary returns.

Ready? Here goes...

When the AD ratio exceeds 1.8, we get a buy signal.

How do we calculate the AD ratio?

It is simply the number of stocks that advance each day divided by the stocks that decline. Since the advance-decline data is very erratic, we smooth the data with the ten-day moving average to arrive at the AD ratio. That is, we take the ten-day average of advancing stocks and divide it by the ten-day average of declining stocks.

The health of any market rally depends on the number of stocks participating in the rally. The more the stocks that participate, the healthier the market rally.

So when AD ratio goes above 1.8, we can say the markets are healthy.

Why?

An AD ratio above 1.8 means the stocks that are rising are almost double the stocks that are declining. When more stocks are going up than going down, we can say we are in a healthy bull market.

Now for the amazing results we promised...

The table below shows the average Nifty returns one month, three months, six months, and twelve months after we got the AD ratio signal - that is, when AD ratio crossed 1.8 - over a seventeen year period from the year 2000.

Note that if the signal repeats during the return calculation period, we ignore it.

  Average Returns (AD Ratio > 1.8) Total Signals All Periods Returns
One Month 4% 17 1%
Three Month 6% 16 3%
Six Month 13% 12 8%
Twelve Month 34% 8 18%
Source: dailyprofithunter.com

What this means is that when the AD ratio crosses 1.8, you can go long the Nifty for a one-month average return of 4%.

The all period average return is only 1%, meaning the AD ratio signal outperforms 4:1.

In total, we got seventeen signals since the year 2000.

Now, if we get repeated signals during the one-month holding period, we consider only the first signal and ignore any repeated signals during the one-month window.

But if the ratio is still above 1.8 after one month of getting initial signal, we re-enter and exit only after one month's time. But if the ratio is below 1.8 one month after the initial signal we exit.

The process is the same for a three, six, or twelve-month holding period.

We have done similar calculations for these different holding periods. And as you can see in the table, the results were also amazing. No matter your trading time horizon, the AD ratio signal significantly outperforms the all period returns.

This market breadth indicator is quite simple. The idea is that if most stocks in the market are going up, the strength of the market is solid.

The only problem is that it only works on the long side. That is, it tells us only market strength and not market weakness.

Therefore, this is just one of several market indicators we track to get a sense of the overall health of the market. Traders should never rely on only one signal indicator. What other indicators can you use?

Stay tuned...

From The Market Wizards...

"If you act in sync with the market, trading can make you rich. If you choose to argue with the market, it will surely make you poor." - Mark Minervini

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