Monday, May 08, 2006

Rest Day After Strength: What Comes Next?

Monday's market took a pause after Friday's vigorous rally, with some of the narrowest trade since the bull market began in 2003. What happens after we get such a rest day after market strength?

I went back to March, 2003 (N = 800) and identified all occasions in which the most recent trading day in SPY had a narrow range of .50% or less (N = 53). The next day in SPY averaged a loss of -.13% (21 up, 32 down), much weaker than the average gain of .06% (446 up, 354 down) for the sample overall.

When the narrow day followed two days in which SPY had been up more than .50% (N = 25) (such as is the case at present), the results were even more bearish. The next day in SPY averaged a loss of -.16% (9 up, 16 down), with weakness extending three days out (-.28%; 9 up, 16 down).

It thus appears that a narrow day after a market rise is not a pause that refreshes, but rather may indicate an exhaustion of the rally. Incredibly, 10 of the last 11 times this pattern has occurred (since 2/05), the market (SPY) has been down three days later.

4 comments:

William said...

That is a good point about Monday’s weakness, I was a little surprised that the market closed down today, because I have noticed that usually after a break out to the upside from a trading range, the market will have follow through, however little it might be. But, today was Monday, and I can think of many Mondays, where the market would at some point reverse Monday’s action either Tuesday or Wednesday. But once again there is a Fed meeting this week, so how much volatility can be expected before that? (not very much I think) I remember a great deal of volume trading between 1324 and 1326 on the initial run up on Friday, so I think if weakness were to persist prior to the Fed announcement, I think the market would find a base there.

Brett Steenbarger, Ph.D. said...

Yes, good point, there are situational factors at work, given the Fed meeting. Still, I was surprised at the market's struggle to take out Friday's highs. As I note on my Weblog, fewer stocks made new highs today as well in the large caps, small caps, and midcaps. Thanks for the note--

Brett

D TradeIdeas said...

Another great post which we modeled in Trade-Ideas. The work proved to be incredible in its foresight and relevancy. The next day during the market weakness, the strategy produced many winning opportunities. We document the strategy and the next day's results using it here. Thanks again for the inspiration.

Brett Steenbarger, Ph.D. said...

Thanks, David; that is excellent. I really like the idea of using historical pattern studies to try to identify edges in the market and then using screening programs such as Trade Ideas to monitor the patterns in real time. The new highs/new lows data, which also can be followed real time in Trade Ideas, nicely picked up on the recent market weakness.

Brett