Wednesday, February 01, 2006

Broad Momentum Rises: What Happens Next?

Yesterday we saw that broad market declines--ones in which a large number of issues closed below the volatility envelopes surrounding their short-term moving averages--lead to further market weakness in the near term, while declines that are less broad are typically followed by reversal (as we saw in today's market).

In this analysis, we'll look at the same broad momentum variable and see if it is relevant to market rises. Since March, 2003 (N = 724), we've had 37 rising days in which the difference between the number of stocks closing above their short-term envelopes and the number of stocks closing below their envelopes has been 500 or greater. Three days later, SPY has been up by an average of .58% (27 up, 10 down). This is much stronger than the average three-day gain of .11% (207 up, 158 down) for other rising days. Indeed, when the market is up on less than broad momentum, the average three-day gain underperforms the sample overall (.18%; 430 up, 294 down).

What this suggests is that broad momentum leads to trend continuation in the short run, both to the downside and upside. Rising market days without broad momentum do not necessarily lead to market declines, but do offer subnormal returns in the near term. When markets rise on broad momentum, the moves tend to persist over the next several days.

2 comments:

Joe_5000 said...

Where can one get the data to construct the volatility envelopes and what formula is most common?

Brett Steenbarger, Ph.D. said...

Intraday data for individual equities can be aggregated from real time data feeds or purchased historically from vendors such as Tick Data (www.tickdata.com). This is beyond the ability of most traders, however, so it can make sense to monitor momentum in other, simpler ways. For example, the Decision Point site (www.decisionpoint.com) tracks the proportion of issues above or below various moving averages. Similar data can be found on the Barchart.com site and through the Lowry's Reports service. My sense is that these can work well for the purposes mentioned in these analyses, saving traders the need to collect large amounts of data.

To answer your other question, either 1.5 or 2 SD for the envelope is most common a la Bollinger Bands.

Brett