Is the Bullish Percent Index a useful indicator of overall stock market or sector direction by reliably identifying overbought/oversold conditions from which stock prices are likely to revert? In a study published in the 2005 Journal of Technical Analysis, Andrew Hyer relates the simple average Bullish Percent across 40 stock market sectors (BPAVG) to future broad stock market returns. Using weekly levels of BPAVG as calculated by Dorsey, Wright & Associates and overall stock market returns over the next 100 calendar days based on the Value Line Geometric Index for a total sample period of 1/6/98-1/24/05 (about 368 weeks or 26 intervals of 100 calendar days), he concludes that:
- BPAVG provides very useful information about the future performance of the broad market over the next 100 calendar days.
- When BPAVG is below (above) 40%, average returns for the broad market over the next 100 calendar days are positive (mostly, but not consistently, negative). This indicator is more reliable for identifying oversold than overbought conditions. Investors may want to increase equity exposure when BPAVG is low.
- Future returns for the broad market are on average stronger when BPAVG is rising.
- Low values of BPAVG usually correspond to low levels of bullishness from American Association of Individual Investors investor surveys.
The following table, reformatted from one in the paper, summarizes the principal findings of the study. It shows that average returns for the Value Line Geometric Index are generally strongest for lows levels of BPAVG.
Is this study convincing?
The study has methodology issues that potentially invalidate its conclusions, as follows:
- The summary table presents 369 observations, which seems a fairly large sample. However, the number of independent measurements of broad market returns equals the number of non-overlapping intervals of 100 calendar days within the total sample, about 26. In other words, the study uses the information in each of the independent 100-day return intervals an average of 14 times. A sample of 26 is too small to infer a reliable relationship between BPAVG levels and stock returns.
- The study methodology does not account for potential clustering of BPAVG values over relatively short calendar intervals. For example, if the four observations in the 10-19% range occurred in closely bunched weeks, all four would relate to largely overlapping future 100-day return intervals. From a statistical point of view, such overlap would mean that information in all four observations is hardly greater than the information in one of them. From a practical point of view, a trader committing funds to the first signal for 100 days would not be able to use the next three signals.
- The study offers no rationale for using a forecast interval of 100 calendar days. If the author chose that interval after testing many others to find one with convincing results, then the conclusions probably overstate any actual relationships due to data snooping bias.
If the study were recast such that the sampling interval is comparable to the forecast interval, its statistical conclusions may be unconvincing and its economic value for systematic trading unattractive.
In summary, weaknesses in the methodology of this study substantially undercut its conclusion that the average Bullish Percent across sectors is very useful for predicting stock returns.
It may be that such indicators add no information to that provided by past returns alone.
