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New or False Highs and the 3% rule

One by one key US stock indexes have recorded new all-time highs. So, with these record highs why are investors still cautious on the stock market? And, why are some market commentators and investment professionals questioning that these are not record highs but false highs?


Over the years, we have studied a few technical driven trading models and quant/computer generated algorithms implemented by major trading firms as to how they validate buy/sell signals. We have noticed that many will deploy technical/quant factors such as volume expansion, market breadth breakout, momentum breakout and other technical credentials to confirm new all-time highs and sustainable breakouts.


Let’s for argument sake we have vetted these technical factors and they confirmed technical breakouts to new all-time highs. Does this then give us a “green light” to pursue these markets and securities? One interesting price metrics that we believe will provide investors with confidence that these are indeed real breakouts and not false or temporary breakouts is by adhering to the 3% rule of an index or security trading above their respective new highs or major technical breakout levels. That is, when a security or stock market index in question first trades to new record highs or completes a major technical breakout pattern (i.e., head/shoulders bottom, ascending triangle, double bottom, and etc.) it is not necessarily a confirmed breakout until it can sustain above its 3% threshold level. Although a trader or investor may give up some gains, by deploying the 3% rule this will lessen the number of bull traps or false breakouts.


We can understand why investors and traders have been leery of new all-time highs and technical breakouts as the S&P 500 Index (SPX) have generated three (3) false breakouts or have lacked the strength to follow through after setting new highs or completing major technical breakouts over the past 2-years. For instance, SPX recorded an all-time high of 2,872.87 on 1/26/18. A subsequent rally to new all-time high at 2,940.91 (9/21/18) did not fulfill the 3% rule, as SPX needed to trade to 2,959.06 to confirm new highs/breakouts. Again, a new SPX high was recorded at 2,954.13 on 5/1/19, but the 3% rule states that SPX must reach 3,029.14 to validate new highs.


As we fast forward to the past week, SPX has just set record highs above the prior 7/26/19 high of 3,027.98. Based on the 3% rule, we would like to see SPX also trade to at least 3,118.82 to confirm that this was indeed a valid new all-time high. By applying the same methodology to the recent 2-year broadening top/bottom breakout and/or 2-year head/shoulders bottom breakout at 3,059 on 11/1/19 the 3% guideline required SPX trading to 3,150.77 to confirm the major technical breakout.


Attached below are major US market indexes that have recently broken to new all-time highs or are close to establishing new record highs and/or nearing major technical breakouts.


Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com


Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

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