Friday, October 19, 2007

Big Down Day in the Stock Market: What Comes Next?

Well, it started with divergences in our indicators last week and then picked up with a repeat of the risk aversion trade from August, as noted in the Twitter comments. Friday's market truly accelerated the weakness: we saw 456 new 20-day highs across the major exchanges and 1805 new lows. The downside momentum was evident in the Demand/Supply data, with Demand (an index of the number of stocks closing above the volatility envelopes surrounding their short- and intermediate-term moving averages) at 21 and Supply (those closing below the envelopes) at 204.

I went back to the start of 2003 (N = 1185 trading days) and found 22 occasions in which we had more than 1000 new 20-day lows and Supply greater than 150. These, like Friday, are days in which we have seen high downside momentum, with a number of stocks extended to the downside.

Interestingly, of the 22 occasions, 16 registered a lower daily close in the S&P 500 Index (SPY) during the next week of trading. Indeed, five days after the strong momentum down day, SPY was up 11 times and down 11 times, for an average loss of -.14%. That compares poorly with the average five-day gain of .23% for the remainder of the sample.

In sum, broad weakness and downside momentum are often followed by further price weakness in the short run. It's when index lows occur with fewer stocks making fresh price lows on less extreme downside momentum readings that reversals are most likely to occur.

RELEVANT POST:

Stock Market Momentum and Short-Term Price Cycles
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2 comments:

Brandon Wilhite said...

Brett,

I was hoping to see a post like this when I came here this morning. The USD/CHF and USD/JPY both made strong moves on Thursday (especially CHF), and USD/JPY also had strength right up to the close on Friday. The CHF economy had some strong data this week...and two of the currencies it's sold against, GBP and USD, had some bad data. With the prospect of another rate cut this month and the stock market acting as it is, I would not be surprised at all to see a sort of feedback loop develop like we experienced in February and July/August. Personally I believe that some of the moves in USD/JPY this week were a result of that kind of effect. Hopefully, if a loop does develop, it won't be as bad as August. Of course this is just one possible scenario, but whatever happens, I'm going to have my eyes peeled open on Sunday night and Monday.

BW

Brett Steenbarger, Ph.D. said...

Hi Brandon,

Very good point; once these risk aversion themes kick in, we see multiple asset classes trading in correlated fashion and feedback loops galore as everyone manages risk and becomes a short term trader.

Brett