Wednesday, February 01, 2006

Broad Momentum Rises: What Happens Next?

Yesterday we saw that broad market declines--ones in which a large number of issues closed below the volatility envelopes surrounding their short-term moving averages--lead to further market weakness in the near term, while declines that are less broad are typically followed by reversal (as we saw in today's market).

In this analysis, we'll look at the same broad momentum variable and see if it is relevant to market rises. Since March, 2003 (N = 724), we've had 37 rising days in which the difference between the number of stocks closing above their short-term envelopes and the number of stocks closing below their envelopes has been 500 or greater. Three days later, SPY has been up by an average of .58% (27 up, 10 down). This is much stronger than the average three-day gain of .11% (207 up, 158 down) for other rising days. Indeed, when the market is up on less than broad momentum, the average three-day gain underperforms the sample overall (.18%; 430 up, 294 down).

What this suggests is that broad momentum leads to trend continuation in the short run, both to the downside and upside. Rising market days without broad momentum do not necessarily lead to market declines, but do offer subnormal returns in the near term. When markets rise on broad momentum, the moves tend to persist over the next several days.