Friday, November 18, 2022
LPL Research explores point and figure analysis and how it can be utilized to define market conditions. Despite recent overbought readings, history suggests buying pressure may not be over.
Point and figure (P&F) analysis dates back to the 19th century. In an era with no computers to record stock prices every day, filtering price based only on a predefined box size (consisting of columns of X’s or O’s) became a popular solution to track price action for investors. In general, rising prices equate to a column of X’s and declining prices are represented by a column of O’s. Based on the composition and position of these columns, objective buy and sell signals can be easily generated.
Jeremy du Plessis, widely considered an expert on the subject, considers P&F charts the ‘mouthpiece of the market’ as the “‘chart moves only when the market moves and only where there is significant movement in the price” (Jeremy du Plessis).’
The P&F chart below shows the S&P 500 based on data over the last year. The box size is 50 points and reversals of a column require a price move of at least three boxes. For example, in order to add a new column of O’s right now, the S&P 500 would need to close below 3,900. Similar to the S&P 500 price chart, you can also depict a clear price downtrend despite some near-term breakouts.
Applying P&F Analysis to Define Broader Market Conditions
The Bullish Percent Index (BPI) evolved P&F analysis into a market breadth tool. This indicator ranges from 0% to 100% and represents the percentage of stocks within an index that have a current P&F buy signal. Readings above and below 50% are considered bullish and bearish, respectively. The BPI can also be utilized to identify overbought (readings above 70%) and oversold conditions (readings below 30%).
The chart below highlights the S&P 500 and its BPI. The current reading shows 70.2%, which is generally considered overbought. However, in a strong uptrend or bull market, overbought conditions should develop as momentum builds.
Historical data supports our thesis that overbought does not always mean the buying pressure is over. The bar chart below highlights forward S&P 500 returns after the BPI crossed above 70 filtered for trade signals at least 10 trading days apart (since 1996). For comparison, we also analyzed when BPI crossed below a bottom 95th percentile reading, which equates to 32 (same 10 trading day filter applied).
BPI Signal Performance
In summary, the recent overbought BPI reading does not mean the recovery off the October lows is over. Forward 12-month returns following an overbought reading averaged 11.3% with 82% of signals producing positive returns. This data also resonates with an old technical analysis axiom, “The most bullish thing a market can do is get overbought and stay that way.”
In terms of oversold signals, they historically outperform after 1, 3, and 6 months, although overbought signals notably have positive performance during these timeframes.
Jeremy Du Plessis. The Definitive Guide to Point and Figure a Comprehensive Guide to the Theory and Practical Use of the Point and Figure Charting Method. Petersfield Harriman House Publishing, 2006.
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