How to interpret the McClellan Summation Index

This week, I was asked if I had an opinion about the reverse Head & Shoulders pattern on the McClellan Summation Index.

I would urge everyone to avoid the use of that terminology when describing McClellan Oscillator and McClellan Summation Index structures. The reason is that association with that named chart formation implies interpretations which are not valid.

A Head and Shoulders pattern on a price chart has certain specific rules for qualification, and also specific expectations based upon it once the structure does qualify. Those do not apply elsewhere, so it can get confusing to use those names. For example, the neckline on a price chart is under no obligation to ever get broken, whereas the return to neutral by the Summation Index mandates an eventual crossing of what would be the equivalent of a neckline drawn on the Summation Index structures. If an event is inevitable under all circumstances, then seeing that event take place does not give us much interpretive value. I can understand what you mean in referring to them by those names, in order to identify the "terrain features" and talk about them, but I hope you get my meaning that the rules for H&S structures on price charts just do not apply.

With that out of the way, I can say that having the Summation Index moving upward is definitely better for the bullish case than having it move downward. Of greater importance to the interpretation of the market is the fact that the Summation Index did not get down far enough in June to mark a bear market bottom. Since we are currently in the 2nd year of a presidential term, that task remains on the market's to-do list, probably for October-November.

The chart below of the Ratio-Adjusted Summation Index (RASI) provides a few points for discussion and interpretation. The Ratio Adjusted version adds a step to the calculation process, dividing the A-D difference by Advances plus Declines, and then multiplying the result by 1000 to get it back into the realm of real numbers. In effect, we are mathematically pretending that there are always exactly 1000 stocks trading. As such, it is better for multi-year comparisons.

One of the most noticeable points is that the amplitudes have been decreasing over the past four years. Each successive up wave seems to occur on lower energy. There has still been enough impulse energy to get the RASI up above the important +500 threshold on each of the upward waves since 2003, but that is coming more into doubt as that declining tops line gets lower and lower. A failure to reach +500 is a sign that the bulls don't have the energy to achieve escape velocity. The circled example at the left end of the chart shows such a failure.

The other big point worth illustrating has to do with the smoothness or bumpiness of the RASI, since that conveys a lot of information. Smooth moves imply strength for the direction in which they unfold. It can be bullish strength, or bearish strength. Point 1 on this chart shows a smooth move downward in the summer of 2002, when the bears were clearly very strong, and it took all the way into early 2003 for that strength to be dissipated. Coming off of the March 2003 market bottom, we saw Point 2 as a very smooth upward move by the RASI, telling us that the bulls were now strong. The very high RASI reading on that up wave also conveyed a message of bullish strength for a long time to come.

But at Point 3, the bulls' strength was not as good, as the RASI made a bumpy advance. What followed was a consolidative market in 2004, with the bulls not finding their strength again until after the RASI had fallen all the way to -765 in May 2004. Point 4 showed another bumpy advance, which implies weakness for the bulls, but it also was a pretty high move upward by the RASI which contradicts that weakness message. Prices moved upward, but not by as much as we saw back in the up moves of 2003.

The latest two up moves at points 5 and 6 have been very smooth up, and bumpy down, implying that the bulls still had the power and the bears did not. We saw nice price moves on those smooth RASI up moves despite the diminishing amplitudes of the RASI peaks.

Now we are in a more questionable time. If the RASI is going to make a bumpy up move on this current up move, as it so far seems to be doing, that will convey the message that the bulls' strength is finally waning, and the bears will be offered an opportunity to try to have their fun. One bump is not enough to make a full interpretation off of.

The other trait to look for is how high the RASI gets this summer. I suspect that we will not see the RASI be able to reach the +500 threshold this time, and that such a failure will confirm the weakness of this rally and the beginning of the decline into the 4-year cycle bottom due this fall. The rising bottoms line on the RASI ought to get penetrated on such a decline.

The one caveat to that point is that so far, the bears are not showing that they have the strength to pull it off. RASI decline from the January RASI peak has been about as bumpy as it can possibly be, implying weakness among the bears. That bears' weakness condition can change, but for now it is the default interpretation.

Tom McClellan
www.mcoscillator.com

Tom McClellan is the Editor of The McClellan Market Report, an 8-page report covering the stock, bond, and gold markets, which is published twice a month and the Daily Edition of the newsletter. Subscribers range from individual investors to professional fund managers. Tom is a graduate of the U.S. Military Academy at West Point where he studied aerospace engineering, and he served as an Army helicopter pilot for 11 years.

In June 2006, Timer Digest ranked The McClellan Market Report #1 Timer for the past 3 and 12 months, and #2 Timer for the past 6 months. In Timer Digest's 22nd Annual Review, The McClellan Market Report was ranked 2005 #1 Bond Timer of the Year, 2005 #2 Stock Market Timer and #1 Gold Timer over the last 10 years.