Assessing the market's psychology is any trader's or investor's ultimate goal as today's actions determine tomorrow's consensus of value (the prices of stocks, futures, options, commodities, etc.). There are some fairly esoteric indicators—and there are more being constructed all the time—that are used to refine well-known measures for the purpose of creating more valid predictors of market behavior, for the present and the future. (See also: Behavioral Finance.)
Some of the more interesting (and often complex) measures of crowd psychology include the Herrick Payoff Index (HPI) and the New-High New-Low Index (NH-NL).
Herrick Payoff Index
John Herrick's technical index tracks volume, price and open interest into an aggregate value that is meant to capture trends and their reversals. HPI uses data—preferably of all contracts (futures and options)—from a period of at least three weeks. HPI applies these to prices of the most active delivery month. Instead of using closing prices, the HPI measures mean prices, which are the average consensus of value for the day. Quite simply, when volume increases, the absolute value of the HPI also increases.
Further, you may remember that a rising open interest is a bullish signal in an uptrend and a bearish signal in a downtrend. Conversely, a falling open interest is a bearish signal in an uptrend and a bullish signal in a downtrend. A flat open interest is neutral. We can apply these principles to the HPI: When it breaks its longer-term trendline, it gives a leading signal, indicating that a price trend is likely to be broken through. When HPI crosses its center line, the price trend is confirmed.
But we can extend these principles further: When prices reach a new low but the HPI records a higher volume than a previous decline, a buy signal is issued (this is a bullish divergence). When the HPI turns up from this second bottom, the trader has an opportunity to place a protective stop below the latest low price. The corresponding bearish divergence occurs when prices hit a new high, but the HPI reaches a lower top. The short-sell signal occurs when the HPI turns down, so the trader would use a stop above the latest high. The Herrick Payoff Index is an excellent indicator of the market's overall bullishness or bearishness. When the HPI is above its center line, bulls are in control. When the HPI lies below the center, a trader would be wise to sell short. (See also: World's Wackiest Stock Indicators.)
New-High New-Low Index
Applicable only to the stock market, the NH-NL measures how many stocks have reached new highs and how many stocks have reached new lows on any given trading day. The numerical value for NH-NL is simply the result of new lows subtracted from new highs, and is often used to predict a new market bottom or top when it diverges from actual prices.
For any given stock, a new high is reached when the bulls are in control. A new low indicates that a plethora of bears have ganged up on the bulls to drive the stock ever downward. The NH-NL acts as a leading indicator to the market's bullishness or bearishness: When NH-NL rises above its center line, the bulls lead the market. When it falls below the center line, the bears are the market's leaders. If both the market and the NH-NL reach new highs, the bullish trend is likely to continue. When both market and NH-NL reach new lows, bearishness will likely persist. (See also: Traders' Index Analyzes a Manic-Depressive Market.)
Divergences are also extremely important in interpreting the NH-NL. If the market rallies, but NH-NL declines, the uptrend is likely reaching its high point. Similarly, if NH-NL hits a lower peak than the market's new high, a bearish divergence is realized. This means that the rampaging bulls are weakening somewhat. If stocks fall but NH-NL moves higher, an uptrend may be imminent. If the NH-NL reaches a shallower bottom than a new low, the bullish divergence indicates that bears are beginning to lose their strangle-hold.
In absolute numbers, a major reversal is often considered to be a peak in NH-NL at +100 or less. If higher than +100, the market may not collapse, but it will likely not hit new highs. If the NH-NL low approaches -100, then a major upside reversal is imminent. If, however, NH-NL is lower than -100, the downtrend is losing a bit of strength, but it will probably not immediately reverse course to the upside.
The NH-NL also indicates appropriate trading actions for existing open positions. If NH-NL rises, long positions can be held and even increased. If, however, NH-NL declines when the market rallies, long positions should be liquidated. Falling NH-NL confirms short positions; but shorts need to be covered if the market falls and NH-NL rises. On a flat market day, a rising NH-NL is a bullish message, and a falling NH-NL encourages shorts. Over the long term, if NH-NL is negative for some time then suddenly rises above the center line, a bull market is nigh. If it stays positive for a long time before falling below the center line, your best position is short.
The Bottom Line
Measuring market sentiment and crowd psychology may never be an exact science, but there are indexes that can help with your analysis. John Herrick's technical index will help you analyze whether we're in a bull or bear market, and the NH-NL can be applied to the stock market to help predict tops and bottoms. They're not perfect, but when used with other tools they can help with your trading and analysis. (See also: Economic Indicators Tutorial.)