Thursday, January 29, 2009

Reversal and Momentum Effects Following Surges in Stocks Making New Highs

One pattern that I've seen play out on multiple timeframes is that price breakouts that lead to a surge in the number of stocks making new highs tend to be followed by consolidation/reversal in the short run, but continuation thereafter. This sets up useful trades in which initial pullbacks following these surges can make nice entry points for subsequent upside moves.

Going back to late 2002, when I first began collecting these data (N = 1572), I looked at what happened in the S&P 500 Index (SPY) following days in which the number of stocks making new 20-day highs across the NYSE, NASDAQ, and ASE exceeded 1500 (N = 213). Interestingly, ten days after the surge in new highs, SPY averaged a gain of only .05% (122 up, 91 down), compared with an average gain of .08% (787 up, 572 down) for the remainder of the sample.

When we go out 30 days, however, we find that the surge in new highs leads to an average gain of .85% (143 up, 70 down), compared with an average rise of only .13% for the rest of the sample (801 up, 598 down). The surge in strength does not necessarily result in significant near-term gains, but it is common to see momentum carry the market higher in the longer run. In a future post, I will illustrate this pattern at intraday time frames. The links below illustrate the importance of understanding momentum dynamics in markets.