Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 23:12 (36-41): Breadth Of Fresh Air by Gregory L. Morris
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by Gregory L. Morris
The significance of the levels of the McClellan sum-
mation index can help improve your trading results.
INDICATORS
Heres A Filter For Short-Term Indicators
select one market breadth indicator that would tell
you when to invest and when to be on the sidelines,
which would it be? During my research, I discovered
it would be the McClellan summation index.
Why, you ask? Ill tell you but before I do,
heres a quick rundown on the topics Ill have to
cover in order to fully explain why:
An exponential moving average (EMA), which
gives more weight to the most recent data and is
quicker at responding to price action than the
more common simple moving average.
Advancing issues (A = advances), which are the
number of stocks that increased in price during
the day.
Declining issues (D = declines), which are the
number of stocks that declined in price during
the day.
The advance decline line, which is the daily
difference between advances and declines, and
then a running sum is maintained each day.
The McClellan oscillator, which is calculated by
subtracting the 39-day exponential moving av-
erage from the 19-day exponential moving av-
erage of net advances (A D). And finally,
Breadth Of Fresh Air
The McClellan summation index, which is the
daily summation of the McClellan oscillator:
McClellan oscillator:
19-day exp. avg. (A D) 39 day exp. avg. (A D)
McClellan summation index:
(McClellan oscillator)
was writing my second book, The Com-
plete Guide To Market Breadth Indica-
tors, when I became aware of some sig-
nificant facts. Heres one: If you had to
The McClellan summation index has developed a
life of its own. Not only is it a good indicator of
longer-term breadth and direction, but the levels of
the index are also important. Its creators, market
technicians Sherman and the late Marian McClellan,
have made a couple of important modifications to
this indicator since its inception in the 1960s.
A LOOK AT THE MODIFICATIONS
One of the modifications to the McClellan summa-
tion index is to use a ratio of (A D)/(A + D) instead
of (AD). This alleviates the problem of the growing
number of issues on the exchange being analyzed.
This is a way to normalize a dataset so longer-term
analysis can be accomplished. You could also use
(A D)/(Total issues) with similar results.
One of the problems with using an indicator that is
calculated as a running summation, like the advance
decline line and the McClellan summation index, is
that the numbers that make up the indicator itself are
tied to the first datapoint or starting date of the
calculation. This became a problem when financial
news television network FNN (and later, CNBC)
showed the values of the McClellan summation
index each day on television. Those with analysis
software could not duplicate that number because
they did not know when the calculation began. Add
to that any data errors or missing data would accumu-
late and no two analysts could get the same results.
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Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 23:12 (36-41): Breadth Of Fresh Air by Gregory L. Morris
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Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 23:12 (36-41): Breadth Of Fresh Air by Gregory L. Morris
In the early 1990s, a mathematician named James Miekka
modified the McClellan summation index formula so it could
be calculated for any day in history simply by knowing the
days values for the 19-day EMA and the 39-day EMA of the net
advances (or ratio, if using that). This calibration formula will
keep the indicators levels consistent, no matter when you
begin the calculation. I should note that I devoted an entire
chapter in the aforementioned book to the McClellan indica-
tors along with a section contributed by Jim Miekka with
details of his modifications.
The purpose of this article is to make you aware of the
significance of the levels of the McClellan summation index.
Applied to your investment game plan, this knowledge can
help improve results.
Last year I did a study at PMFM, Inc., a money management
company that bases its investment approach on the use of
technical models. The study showed the performance of the
NASDAQ composite index at various levels of the McClellan
summation index. Let me explain the column headings in
Figure 1.
Average return per tradeThe average gain
on each trade
Compounded annual returnThe total return
from the beginning of the study
Compounded annual return while invested
The total return only when invested in
the NASDAQ
Percent of time investedThe percentage of
the 26-year study that you were invested
Ulcer indexA measure that shows the pain of
holding a security in a down market
Maximum drawdown (entry)The percent-
age that a holding went against you
Buy & hold (bottom row)Contains the statis-
tics for a buy & hold strategy.
McClellan Summation Index Research
1/2/1979 12/31/2004 (26 years)
Adjusted for zero-level neutral and (A-D)/(A+D) ratio, using NASDAQ data.
Note that Trades per year and Compounded annual
return columns include money market rates of return when
not invested in the NASDAQ composite index.
Heres how to use this table. If you invested in the NASDAQ
composite index when the McClellan summation index rose
above the selected level and then you got out when it dropped
back below, you would experience the results shown on the
row for that level.
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FIGURE 1: PERFORMANCE OF THE MCCLELLAN SUMMATION INDEX. Would you rather be in the market only when conditions are in your favor or in the
market 100% of the time?
Level Winning Trades Average Compounded Compounded Percent Ulcer Maximum
Percentage Per Return Annual Annual Of Time Index Drawdown
Year Per Trade Return Return While Invested (Entry)
Invested
>800 76.92% 0.50 5.89% 8.40% 49.74% 6.75% 1.12% -2.55%
>700 86.67% 0.58 6.53% 9.26% 50.92% 8.52% 1.18% -2.71%
>600 70.00% 0.77 5.92% 9.78% 47.91% 10.33% 1.64% -2.85%
>500 50.00% 0.92 5.65% 10.00% 38.74% 13.32% 2.38% -4.11%
>400 55.56% 1.04 5.91% 10.88% 36.81% 16.47% 2.91% -4.11%
>300 55.88% 1.31 5.57% 11.83% 34.08% 21.04% 2.65% -4.10%
>200 57.89% 1.46 5.09% 11.55% 26.31% 26.78% 5.67% -8.12%
>100 58.82% 1.96 4.42% 12.51% 24.48% 34.35% 4.33% -9.59%
>0 54.17% 1.85 5.66% 13.43% 22.38% 44.01% 7.46% -7.93%
>-100 55.77% 2.00 5.68% 13.64% 20.22% 51.80% 8.93% -14.47%
>-200 45.61% 2.19 5.38% 13.12% 17.29% 59.77% 12.83% -18.19%
>-300 56.25% 1.85 8.31% 16.09% 20.71% 66.38% 11.93% -21.48%
>-400 52.27% 1.69 9.54% 16.02% 19.45% 71.88% 12.76% -19.95%
>-500 50.00% 1.61 9.55% 14.80% 17.01% 76.40% 18.17% -22.33%
>-600 55.26% 2.92 4.92% 12.91% 14.04% 80.62% 22.03% -23.48%
>-700 53.12% 1.23 13.63% 12.83% 13.54% 84.96% 24.37% -26.55%
>-800 41.38% 1.11 17.98% 13.25% 13.79% 88.22% 23.23% -26.77%
B & H N/A N/A N/A 11.86% 11.86% 100% 27.75% -77.93%
Winning percentageThe percentage of win-
ning years over losing years
Trades per yearThe number of trades based
upon crossing the level
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 23:12 (36-41): Breadth Of Fresh Air by Gregory L. Morris
21-day average
65-day average
McClellan Summation Index
NASDAQ Composite Index
M J J A S O N D 03 F M A M J J A S O N D 04 F M A M J J A S O N D 05 F M A M J J A S
1,000
900
800
700
600
500
400
300
200
100
0
-100
-200
-300
-400
-500
-600
-700
-800
-900
-1,000
-1,100
-1,200
-1,300
2,300
2,100
1,900
1,700
1,600
1,500
1,400
1,300
1,100
1,800
1,200
2,000
2,200
1,050
There are two levels worthy of comment. One, the com-
monly used zero level, reveals you were invested less than half
the time (44.01%) and had to endure a maximum drawdown of
-7.93%. The compounded annual return while invested was
22.38%, which is about twice the return if you had just bought
the NASDAQ composite at the beginning of the study and held
it till the end. The latter is shown on the bottom row as B&H
(buy & hold).
The other level that is noteworthy is the +300 level. Here you
were able to reap the same return (Compounded annual
return) as the buy & hold (B&H) strategy with one big
differencemuch less risk. By being invested only a fifth
(21.04%) of the time and enduring only a -4.1% maximum loss
while invested (Maximum drawdown), you would enjoy the
safety of being completely out of the market for about 20 years
out of the 26 in this study. What did I mean by much less risk?
If you bought and held the NASDAQ composite index for the
entire 26 years, you would have endured the -77.93% drop in
your account at one point. A loss of 78% requires a gain of more
than 450% to get back to even no thanks.
Figure 2 shows the McClellan summation index for the last
four-plus years. This is the summation index using NASDAQ
advance and decline data as used in the PMFM study. The
horizontal lines are at zero and +300 (referred to previously).
You can see from Figure 2 that whenever the McClellan
summation index is above +300, the market (NASDAQ compos-
ite index) is generally rising. You can see that this is also true
for the zero level. Building a model with this information is not
the purpose here, but there are a few things you can consider
when measuring the usefulness of this indicator:
1 Considering the direction of the McClellan summa-
tion index could probably yield some good returns in
addition to its level. The summation index will always
rise whenever the McClellan oscillator is positive. A
rising McClellan summation index generally follows
a rising market, and similarly on the downside.
FIGURE 2: McCLELLAN SUMMATION INDEX, THE LAST FOUR YEARS. Note the importance of the zero and +300 level in the McClellan summation index. Whenever the
index is above these levels, the market is rising. In addition, the 65-day moving average acts as an additional filter.
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Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 23:12 (36-41): Breadth Of Fresh Air by Gregory L. Morris
You probably arent reading
this magazine because you
have a buy & hold mentality.
2 In addition, using the McClellan summation index
and a filter of a 65-day simple moving average on the
NASDAQ composite would also probably improve the
model. Whenever the NASDAQ composite is above its
65-day average and the McClellan summation is above
zero, you have a very comfortable investing climate.
3 And finally, you could also generate a fairly good
system by using a smoothing (moving average) of the
McClellan summation index and the index to generate
buy and sell information. A 21-day simple average is
shown in Figure 2. A simple method like this usually
generates too many signals, but used in conjunction
with the McClellan summation index level, it im-
proves considerably.
BUY & HOLD COMMENTS
You probably arent reading this magazine because you have
a buy & hold mentality. The Wall Street cheerleaders (other-
wise known as brokerage firms) tout the Ibbotson study of 1976,
which showed that stocks returned about 10% per year from
1925 to 2005. That is an average, however, and if you are a giant
tortoise, you might be able to obtain that 80-year average. Most
investors have a good 15- to 20-year investment horizon and
there are many 15- to 20-year periods in that same 80 years
where you would have significant losses. You must use some
tool to help you avoid the times when the market is risky.
DRAWDOWN COMMENTS
Drawdown is a measure of how much
a position will go against you during
a trade. If you thought you were will-
ing to accept a system that incurred a
maximum drawdown of 10%, it means
that the biggest drawdown over the
period studied was 10%. What it does
not tell you is how many times you
also had to endure drawdowns of just
less than 10%, say 9.5% which is just as painful as 10%.
Some software will also generate drawdown data from
peaks. This is a measure of how far a position has dropped
from its highest point while in the position. This drawdown
measure is best used as a volatility measure when comparing
different systems.
CONCLUSION
From Figure 1, you can see that based upon certain levels of the
McClellan summation index, there are times that present a
lower risk environment for investing. This is important. By
knowing this simple piece of information, you can develop
models and systems by making the level of the McClellan
summation index a significant part of the decision-making
process. For example, when the index is above a certain level,
you can use slower timing on other indicators than you would
if it is below that level. You can do this because you know you
are in a lower risk environment. If you dont want to trade very
often, you can choose a level that is higher than a level that
more active traders would use.
Finally, when the McClellan summation index is above
zero, you are in a market climate in which really bad things
rarely happen. The net advances are increasing and the market
is liquid. As the index continues to rise, this liquidity is even
more widespread; in fact, it is accelerating. These are the times
when the quality of investment returns are at their best. This is
not the time to be underinvested. Conversely, when the
McClellan summation index is below zero, you are in a market
climate where liquidity is drying up, bad things happen more
often than not, and you do not want to be overinvested.
The bottom line: Pay attention to this indicator. It is a great
filter for your shorter-term indicators.
Greg Morris is a portfolio manager with PMFM, Inc., a consult-
ant to StockCharts.com, president of G. Morris Advisors, Inc.,
and a retired airline pilot. From 1996 to 2002, he was CEO of
MurphyMorris, Inc. He is also the author of Candlestick
Charting Explained.
SUGGESTED READING
Hartle, Thom [1994]. Its All In The Family: Sherman,
Marian, and Tom McClellan, interview, Technical Analy-
sis of STOCKS & COMMODITIES, Volume 12: June.
McClellan, Sherman and Marian [1989]. Patterns For Profit,
McClellan Financial Publications, Lakewood, WA.
Miekka, James. The Sudbury Bull And Bear Report, St. Peters-
burg, FL (727) 866-8682.
Morris, Gregory L. [1995]. Candlestick Charting Explained:
Timeless Techniques For Trading Stocks And Futures,
McGraw-Hill.
_____ [2006]. The Complete Guide To Market Breadth Indica-
tors, McGraw-Hill.
www.stockcharts.com
Greg Morris Breadth Indicator Tool Box, Equis International,
www.metastock.com/gmi
www.masterdata.com
McClellan Market Report, www.mcoscillator.com
PMFM, Inc., www.pmfm.com
Ultra Financial Systems, www.ultrafs.com
S&C See Traders Glossary for definition