Sunday, June 25, 2006

Why It's Valuable to Track the Market Herd

In my upcoming Trading Markets article, I will be examining the ratio of advancing to declining volume as an indication of herd-like behavior in the market. I do this both in the traditional fashion of cumulating volume in advancing stocks vs. volume in declining stocks and in a new, intraday version that cumulates volume in advancing vs. declining ES time periods. The moral of the story is that it's worth tracking the behavior of the trading herd.

Going back to 2004 (N = 621 trading days), we've had 42 days in the S&P 500 Index that have been up by 1% or more. Overall, the market has been up by an average of .06% the next day (24 up, 18 down), not much of an edge over the average gain of .02% (343 up, 278 down) for the entire sample.

When we divide the strong up days in the S&P in half based on the ratio of advancing stock volume to declining stock volume, however, we see an interesting pattern. When the S&P 500 is up strong and volume is heavily concentrated among advancers (i.e., the herd is buying), the next day in the S&P averages a loss of -.07% (10 up, 11 down). When the S&P 500 is up strong and volume is not heavily concentrated among advancers, the next day in the S&P averages a gain of .19% (14 up, 7 down).

It thus appears that strong market rises are more likely to persist in the near term if they are not accepted by the herd.

How about during market declines?

Since 2004, we've had 47 days in which we've had a decline of 1% or greater. Overall, the next day in the S&P 500 Index has been up by an average of .04% (28 up, 19 down). Again, that's not much of an edge compared to the average gain of .02% (343 up, 278 down) for the entire sample.

Here, too, though we see a pattern. When the S&P is down sharply and volume is concentrated in declining issues (N = 23), the next day averages a loss of -.03% (11 up, 12 down). When the S&P is down sharply and volume is not concentrated in declining issues (N = 24), the next day averages a gain of .11% (17 up, 7 down).

What that means is that sharp declines are more likely to persist the next day if the herd is selling. When the decline is large but selling is not indiscriminate across issues, we're more likely to have a snap back the next day.

Finally, let's look at market days that are relatively flat. Since 2004, we've had 84 days in which the S&P 500 Index has closed within a range of plus or minus .10%. The next day, the S&P has averaged a gain of .02% (44 up, 40 down), no edge over the sample as a whole. When volume was relatively concentrated in advancing stocks, however, the next day in the S&P averaged a loss of -.05% (20 up, 22 down). When volume was relatively concentrated in declining stocks, the next day averaged a gain of .10% (24 up, 18 down).

I've looked at this over multiple time frames and the results are similar. When volume is concentrated at one end of the extreme or the other, it generally has meaningful implications for the market's near-term performance.