Today's Market Debate Hangs by the Arms

SAN FRANCISCO -- Stocks drifted lower on a quiet day in what is expected to be a quiet week on Wall Street. But in the background, some voices are being raised in the ongoing debate about the quality and interpretation of sentiment gauges.

Today, the debate centered specifically around the Arms Index, which measures the ratio of advancing issues to declining issues by the ratio of advancing volume to declining volume. The index will rise and fall depending on whether volume is heavier in advancing stocks or declining issues. The index is often used as a measure of sentiment -- which is a contrarian indicator. Thus, a higher Arms Index reading is considered to be bullish while a lower one is viewed as a bearish, or overbought, signal. This "ratio of a ratio," you'll recall, was a key element to the bullish call made last week by Don Hays of Hays Advisory Group.

Hays noted the 10-day moving average of the Arms Index had recently hit levels not seen since mid-March. In creating this double top, the index repeated a pattern evident at key market bottoms in 1962, 1974 and 1987.

But in a research report today, Thomas McManus, equity portfolio strategist at Banc of America Securities, argued the composition of New York Stock Exchange listings has changed so much in recent decades that it's unfair to make historic comparisons using the Arms Index.

Specifically, McManus noted the dramatic increase of closed-end funds in the past decade; both closed-end funds and preferred stocks are included in the advance/decline ratio used in the Arms Index, hence "spoiling the calculation," he said.

The NYSE said there were 426 preferred stocks listed on the exchange in July vs. 566 in December 1991. But the exchange did not have historic information on the number of closed-end funds, of which 386 were listed as of the end of last month.

The strategist sought to find a purer Arms Index reading by stripping out such issues. First, he calculated the 10-day average of the index using the NYSE-listed issues in the Russell 3000 Index. That produced an Arms Index reading of 1.64 on Aug. 17 vs. the historically high 2.65 produced by the traditional method of calculation.

Second, he calculated what the Arms Index would be using Russell 3000 stocks listed on all three exchanges, which produced a reading of 1.71.

Both measures show a "large number of uncorrelated issues [i.e., the preferred and closed-end funds] can wreck the calculation," he concluded. "I would throw the whole thing out."

As you might expect, Hays defended the use of the Arms Index when I called to ask him about McManus' critique.

"Every time [the Arms Index] gives a signal, it is always described by those that want to be bearish as not being descriptive 'this time,' " Hays said. The index "might have changed somewhat -- but it's still working. It's worked every time [and] has never let me down before. I don't think it will this time."

The veteran strategist said his confidence about the Arms Index's signal is heightened by the fact it is being "confirmed" by other indicators such as the equity put/call ratio (particularly the 15-day moving average) and the shrinking number of stocks making new 52-week lows.

"That is what happens at bottoms -- people always feel they have to pull indicators out, and find excuses to disbelieve," he said. "I choose to stay with 'em until they kill me."

( Death be not proud, I guess.)

Anticipating such criticism, I asked McManus how he would reply to a charge he is simply manipulating the statistics to conform to his (currently bearish) view of the world.

First, he said, it's impossible to do a similar deconstruction of the Arms Index at other points in history to see if the index would have called those bottoms when nonequity issues were stripped out. That's because traditional databases don't account for stocks that have since been delisted for reasons such as mergers, he said.

Second, McManus compared the Arms Index with an assembly line. If widgets coming out of the line are suddenly bigger and you see the gauge that measures them has changed, "you either go back to the old gauge or derive a new relationship," he said.

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For the record, it should be noted that Hays isn't the only market watcher citing the Arms Index as a reason for optimism, and McManus isn't the only observer to be skeptical of its signals.

Furthermore, neither Hays nor McManus spoke about the other in derogatory terms. My intent is not to create a combative situation where one doesn't exist.

Hays has "great experience and I respect him a lot," McManus said. "I just don't think you ought to make a big case that everybody is bearish [because of the Arms Index]. That's not the way I see it. The way I see it, he's in the majority."

On Wall Street today, it seems the bears believe most of their peers are bullish, while bulls believe the opposite is true.

That's evident in a review of a subissue of this debate -- the current trend in the advance/decline line, whose recent improvement bulls cite as another supporting factor.

"It is possible that falling bond yields have created a false impression," McManus commented in his report this morning. "That stocks are behaving better than they actually are" because of the performance of preferred stocks and closed-end funds -- particularly bond funds -- which trade more like fixed-income securities than equities. (As an aside, the strategist said the argument that decimalization has propped up the number of advancing stocks is a red herring: "It takes something to move a stock; I don't care if it's a penny or an eighth.")

Nevertheless, McManus noted everything but tech and telecom have fared relatively well in both the past year and since the first six Federal Reserve rate cuts. (It's too early to assess their performance since last Tuesday's action.)

He compared a continued focus (or overweighting) of tech stocks with swimmers who continue to return to New Smyrna Beach in Florida, where the multiple shark attacks have occurred.

"I would think people would start avoiding that beach," he said. "That's what I'm trying to say here: One area is dangerous to your financial health, yet everyone's using breadth in the nontech market to justify holdings of tech."

Hays addressed this issue in his commentary this morning (although he said he hadn't seen McManus' piece, so it wasn't a direct response).

"I am flabbergasted by the people that are discounting the advance/decline line or the new highs because it has so many stocks that are interest rate sensitive," Hays wrote. "Even the advance/decline line that only includes 'operating companies' on the NYSE is also very bullish," as is a chart of the number of stocks trading above their 200-day moving averages.

Hays made a point similar to McManus' about many investors remaining overly focused on tech stocks, which is clouding their ability to accurately assess the underlying trends in the market.

On that, at least, the gurus agreed.

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