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 monitoring market breadth because it tells us what percent of the market is actually participating in a rally or a sell-off. Because many of the broad-based indexes are market-cap weighted (market cap = number of outstanding shares * share price), sometimes just a handful of the largest companies that reside in an index can artificially move the index. For example, if Exxon and Chevron both rally 1.5% due to a positive energy report, because these two companies represent 5% of the S&P 500 index, these two companies alone could 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 provide 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 advancers minus decliners. 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 up-trend. 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 prolonged down-trend and the confirmation of a new long-term up-trend. Prolonged down-trends typically end with the Summation Index below -1200. A strong rise from such a level can signal initiation of a new UP market. This is confirmed when the Summation Index rises above +2000. Past examples of such a confirmation have resulted in upward trending markets lasting at least 13 months, with the average ones lasting 22-24 month.