Thursday, December 14, 2006

Flat Stock Market: Which Way Will We Break Out?

Technical analysis wisdom tells us that the longer a market remains rangebound, the more significant the eventual breakout move. The problem for the trader is that is difficult to handicap the odds of which way the market will make its breakout move.

I decided to draw upon two of my recent posts to address this question, given that we are trading in a five-day range in which the S&P 500 closing price (SPY) has barely budged. Recall that I found reversal effects in the S&P 500 market following periods of uptrending and also following periods of downtrending. Suppose we look at what other, correlated ETFs are doing during the flat period to see if we get a reversal effect from their action.

Going back to 2004, I found 84 occasions in which the five-day change in SPY has been less than +.20% but greater than -.20%. We'll call those relatively flat markets. I then divided this sample in half based on what was happening in the NASDAQ 100 Index (QQQQ).

When SPY was flat over five days, but QQQQ was relatively strong, the next day in SPY averaged a loss of -.01% (21 up, 21 down). When SPY was flat but QQQQ was relatively weak, the next day in SPY averaged a gain of .11% (26 up, 16 down). Indeed, when SPY was flat and QQQQ was down by more than -.50% (as is the case at present), the next day in SPY averaged a healthy gain of .22% (21 up, 10 down).

If we look a bit further out, when SPY was flat over five days, but QQQQ was relatively strong, the next three days in SPY averaged a loss of -.08% (19 up, 23 down). When SPY was flat, but QQQQ was relatively weak, the next three days in SPY averaged a very respectable average gain of .33% (28 up, 14 down).

And when QQQQ has been down more than -.50% during the flat period in SPY? The next three days in SPY have averaged a solid gain of .54% (22 up, 9 down).

Very interestingly, I have not found this reversal effect for the Russell 2000 ETF: IWM. This suggests to me that the smaller-cap Russell may have different characteristics of continuation and reversal than the large cap S&P and NASDAQ stocks. That's a pattern worthy of investigation.

By looking strong and weak sectors during a market's flat period--and by assessing those sectors' tendencies toward reversal or continuation--we might be able to handicap the odds of breaking out in a particular direction in the S&P 500 Index. It appears that, when QQQQ is weak during a flat period in SPY, the eventual reversal in the Qs also tends to lift the Spooz. Let's see if that pattern plays out in the current market.


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