Wednesday, February 24, 2010

Decline in a Firm Stock Market: What Comes Next?

Hats off to Rennie Yang of Market Tells, who identified a worthwhile historical pattern relevant to today's trade. I find the patterns he identifies to be very helpful in framing trading hypotheses. When I see current market action supporting the hypothesis, it tells me that the market is following its historical script--and those are trades that merit conviction.

What Rennie found is that when the S&P 500 Index makes a five-day low but 20-day lows decline from the prior day, the odds of a short-term bounce are quite good.

I decided to frame the pattern a bit differently: I went back to late 2002, when I began collecting these data, and looked for all occasions in which the S&P 500 Index (SPY) made a five-day closing low, but new 20-day lows across all exchanges were fewer than 500. That means that we've seen a short-term decline in a relatively firm market.

That situation has occurred 63 times during that period. The next day, SPY was up 40 times, down 23, for an average gain of .38%. By contrast, on days when we had a five-day closing low with more new 20-day lows, the average next day gain was .18% (212 up, 155 down). All other occasions have averaged a loss of -.03% (758 up, 675 down).

Interestingly, the pattern only held for the next day's trade. Going five days out, there was no further upside edge.

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1 comment:

Daniel said...

That
Huzzah.

Great example of 'greatness'.

Great post.

Apropos of a prior post, to conclude, let OTHERS pin labels on oneself, "great", "lousy", genius, dumbo, whatever.

If we focus on the fundamentals of our trade, stick to our 'knitting' as it were of cross-market correlation analysis... and simple concepts of suppy and demand within the day... our chances of eventually having a tombstone with the word 'great' engraved on it go up.

But.. too self-referential a concern with self-ratings, and self-rankings, risks involving our egos in our work. And investment is not a place for the ego, period.

This post is not so much for you, Dr. Brett, as for some of the other posters, such as my fellow New Yorker, Madi, and a few others. I always cringe whenever I read that a trader has felt ‘self-validated’ when a stretch of events turns out as predicted. I'm speaking of something different from merely noting in a Trading Log that the market movement matched a prediction of how a pattern would resolve itself. I'm talking about that core I'm OK I'm NOT-OK zone of one’s psychological nature.

This kind of detachment insulates us from emotional highs and lows.

We are great because we are children of God, and composed of recycled solar ejecta. That established, let’s get back to watching the ebb and flow of supply and demand as people buy and sell in the marketplace.

Daniel