Chris Rowe

Why Watching the News Can Hurt Your Trading

by Chris Rowe   10/19/09

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Internal vs. External Markets

The "internal market," also known as the "breadth" of the market, is basically the study of the number of advancing stocks versus the number of declining stocks. 

So if a larger number of stocks are advancing, and a smaller number of stocks are declining, the "internal market" is "up" or "strong" or "positive." 

Focusing on the internal market gets me bearish at market tops and bullish at market bottoms.

The "external markets" are what just about everyone focuses on. They're the S&P 500, the Nasdaq, the NYSE and the Dow Industrials. 

The importance of constantly focusing on the market "internals" cannot be overstated. In short, it's what's really happening in the stock market.

In a nutshell: If four out of five stocks are trading up, and you throw a dart and buy whatever stock that dart landed on, there's an 80% chance that you would make money. 

But the fact is that even if four out of five stocks are trading higher, it's possible that the "external markets" can move lower.

The "external markets" are "weighted indices." Different stocks in the Dow, S&P 500, Nasdaq and NYSE have a different amount of influence on the direction of each index.

As of the time of this writing [Oct. 13], Exxon Mobil (XOM), which has the highest valuation out of any stock in the stock market, has a nearly 5% weighting in the S&P 500. The smallest 100 companies on the S&P 500, on the other hand, have a cumulative weighting of approximately 3%.

So if the smallest 100 companies in the S&P 500 move up by 10%, and on the same day Exxon Mobil moved down by 10% while all other stocks in the S&P 500 did not move higher or lower, the S&P 500 index would actually move lower.

Here's how that breaks down:

100 stocks up 10%
1 stock down 10%
The S&P 500 would move lower

People who don't focus on internals/breadth believe that "the market" declined.

This isn't some earth-shattering news that nobody knows about. Many investors know this but don't use it to their advantage. The fact is that the internal market tends to LEAD the external market.

A Fine Line Between Mistakes and Opportunities

What that means is that the internal market changes direction before the external market does. In a market that trends higher, you would usually see the external market as well as the internal market moving higher. But toward the end of that uptrend, before the external market turns around and starts moving lower, the internal market tends to turn around and move lower.

Market tops and market bottoms are where the biggest, most-costly mistakes are made. They also present the biggest opportunities. So, focusing on internals, and looking for divergences between the internals and externals, is essential when investing and trading.

There are a few extremely helpful internal indicators that I use such as different bullish percent indices.

Make Money From Market Strength (and Weakness)

I like to identify both strength and weakness so that I can profit whether the market is moving up or down. I take bullish positions in the stocks with positive relative strength, and I take bearish positions in the stocks with negative relative strength.

Positive Relative Strength: When a security outperforms the market over a significant time frame.

Stock market moves up by 10%, while ABC stock moves more than 10% higher.
Stock market moves down 10%, while ABC stock either moves up, or moves less than 10% lower.

Negative Relative Strength: When a security underperforms the market over a significant time frame.

Stock market moves up by 10%, while ABC stock either moves down or moves less than 10% higher.
Stock market moves down 10%, while ABC stock moves more than 10% lower.

Anyway, that barely scratches the surface of my system, but I hope that whatever it is, YOU have a system. 

If you don't, then it's time to stop trading and start reading because you, or someone else, worked too hard to get the money that you have for you to be investing or trading it without a system.

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