Does Momentum Matter?

One by one we're going to take the major indicators and patterns and see what they're worth. At the end of all this we'll have a core group of patterns with a demonstrated edge, and then we'll start seeing which markets best milk those patterns. And then we'll follow them in real time!

Today we're looking at momentum. My measure of momentum is a version of the Demand/Supply Index that I post on my Trading Psychology Weblog each day. To compute Demand and Supply, we construct an N-day standard deviation envelope around price and then look at the number of stocks closing above (Demand) and below (Supply) their envelopes. For this analysis, I used a 20 day envelope, so that a stock would have to have strong momentum to the upside/downside to contribute to the Demand/Supply figures.

Again, I looked from July, 2003 to November, 2005: a total of 608 trading sessions. Demand was more predictive than Supply. In other words, the number of stocks above their envelope seemed to be more important than the number below it--a result I didn't anticipate. When Demand was greater than 500 (N = 78; more than 500 issues above their envelope), the S&P 500 ETF (SPY) was up .26% (54 occasions up, 24 down). This nicely outpaced the average three-day SPY gain of .13% for the entire sample (359 up, 249 down). When Demand was less than 140, the SPY four days later (N = 83) was up by an average of .50% (57 up, 26 down)--much stronger than the sample as a whole, which was up .16% (344 up, 264 down).

Interestingly, the lack of stocks above their volatility envelope was especially predictive of strength several days out.

When Supply was below 145 (meaning that fewer than 145 issues were below their 20-day envelopes; N = 82), the next day's average change was -.03 (42 up, 40 down), modestly weaker than the average gain of .04% for the sample overall (335 up, 273 down). When Supply was greater than 475 (N = 91), the next three days brought an average gain of .25% (56 up, 35 down) to the SPY, stronger than the average gain of .13% for the sample (359 up, 249 down).

High readings for Supply (a large number of issues trading below their envelopes) thus are associated with strength several days out.

Clearly the momentum figures from Demand/Supply are better at forecasting strength than weakness. In general, the market offers only modest bullish edge when Demand is moderate. Very high readings for Demand, very low readings for Demand, and very high readings for Supply all suggest strength several days out.

Next we'll look at simple price momentum.