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The McClellan Oscillator is one of the more accurate and
modernized market breadth indicators available and is based on the smoothed
difference between the number of advancing and declining issues on a broad-based
index, such as the NYSE Composite, the S&P 500 Index, or the NASDAQ Composite.
We are interested in looking at market breadth, which is based on advancing
and declining issues, because it tells us what percent of the broad market is
actually participating in a rally or a sell-off. Because most of the
broad-based indexes are "float" weighted (based on number of outstanding shares)
or market-cap weighted (market cap = number of outstanding shares * share
price), many times just a handful of the largest companies that reside in the
index can artificially move the index. For example, if Exxon and Chevron
both rally 1.5% due to a positive report out of the Middle East, because these
two companies represent 7.5% of the S&P 500 index, these two companies alone can
move the index; however, the remaining 498 stocks might have all closed
down or flat for the day and we wouldn't have known it. Therefore, it's
prudent to watch a market breadth indicator, like the McClellan Oscillator, to
give us a more accurate picture of what "all" of the stocks are doing in the
index.
Summary of how it's created:
The chart below (top graph) shows an example of daily breadth. Each
tick mark represents one day's reading of advances minus declines. In
order to better identify the trend that is taking place in the daily breadth,
the data is smoothed with an exponential moving average (EMA). It works by
weighting the most recent data more heavily, and the older data progressively
less. The amount of weighting given to the more recent data is known as the
smoothing constant.
The McClellan team uses two different EMAs, one
with a 10% smoothing constant, and one with a 5% smoothing constant, known as
the 10% Trend and 5% Trend for brevity. The numerical difference between
these two EMAs is the value of the McClellan Oscillator, which is shown below in
the dark black solid line.
How it's interpreted:
The McClellan Oscillator offers
many types of structures for interpretation, but there are two main ones. First,
when the Oscillator is positive, it generally portrays money coming into the
market; conversely, when it is negative, it reflects money leaving the market.
Second, when the Oscillator reaches extreme readings, it can reflect an
overbought or oversold condition.
Buy signals are typically generated when the McClellan
Oscillator falls into the oversold area of -70 to -100 and then turns up. Sell
signals are generated when the oscillator rises into the overbought area of +70
to +100 and then turns down. If the oscillator goes beyond these areas
(i.e., rises above +100 or falls below -100), it is a sign of an extremely
overbought or oversold condition. These extreme readings are usually a sign of a
continuation of the current trend.
For example, if the oscillator falls to -90 and turns up, a
buy signal is generated. However, if the oscillator falls below -100, the market
will probably trend lower during the next two or three weeks. One should
postpone buying until the oscillator makes a series of rising bottoms or the
market regains strength.
A healthy bull market is accompanied by a large number of
stocks making moderate upward advances in price. A weakening bull market is
characterized by a small number of stocks making large advances in price, giving
the false appearance that all is well. This type of divergence often signals an
end to the bull market. A similar interpretation applies to market bottoms,
where the market index continues to decline while fewer stocks are declining.
The McClellan Summation Index:
By adding up all of the daily values of the McClellan
Oscillator, one can produce the McClellan Summation
Index. It is the basis for intermediate and long term
interpretation of the stock market's direction and power. When properly
calculated and calibrated, it is neutral at the +1000 level. It generally
moves between 0 and +2000. When outside these levels, the Summation Index
indicates that an unusual condition is taking place in the market. As with the
Oscillator, the Summation Index offers many different pieces of information in
order to interpret the market's action.
Among the most significant indications given by the McClellan Summation Index
are the identification of the end of a bear market and the confirmation of a new
bull market. Bear markets typically end with the Summation Index below -1200. A
strong rise from such a level can signal initiation of a new bull market. This
is confirmed when the Summation Index rises well above +2000. Past examples of
such a confirmation have resulted in bull markets lasting at least 13 months,
with the average ones lasting 22-24 month.
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