Milking Another Pattern: Momentum and Midcaps

Well, before we explore pure price patterns, let's take a look at yesterday's momentum pattern applied to the S&P Midcap (MDY) stocks. We noted earlier that MDY has been a superior trading vehicle to its larger cap counterparts: it is trending better and displays superior volatility. But does it extract greater returns from the momentum pattern?

Once again the analysis looked at daily data from July, 2003 through November, 2005 (N = 608). The average three-day change in MDY during that period was .21% (361 up, 246 down). When Demand (number of stocks trading above their 20 day volatility envelopes) exceeded 500 (N = 78), the next three days in MDY were up by an average .42% (51 up, 27 down). When Demand fell below 140 (N = 83), the next three-day change in MDY was up by .45% (54 up, 29 down). Just as with SPY--but to a greater degree--the market outperforms three days later after upside momentum is either very strong or very weak.

It is interesting to look at the returns in the three-day MDY when momentum is moderate (N = 446). The average change of .13% (256 up, 190 down) is quite modest relative to those strong and weak upside momentum occasions.

Here, too, we see no edge associated with the Supply statistic (the number of stocks trading below their 20 day volatility envelopes). This occurred also with SPY, but not so dramatically. I'm not sure how to explain this, but what seems clear is that upside momentum--its presence or absence--is what matters in the near term. The absence of strength, rather than the presence of weakness, is most predictive. Perhaps this is a pattern associated with bull markets. Might it be different in a bear environment, where Supply would be the essential element? It's an interesting conjecture.

For now, however, we've seen two patterns now: TICK (short-term sentiment) and Momentum (Supply/Demand) that provide an edge when values are strong and weak. Moreover, we've seen that this edge is greater with a superior trading vehicle. Trading the right patterns with the right instruments does indeed appear to be helpful to performance.