Where We Can Find Directional Edges in the Market

In my last post, we found that whether the S&P 500 Index was above or below its 50-day moving average had little predictive value in itself over a period of many years. Rather, it seemed as though *momentum*--the amount that the index was above its average--contained useful information. When we were much above or much below the MA, returns tended to be more favorable than when we were closer to the average.

In this exploration, we'll apply moving average information a different way. Specifically, we'll look at thrust periods in which large numbers of stocks move either above or below a moving average benchmark. The benchmark is a two standard deviation envelope surrounding the 20-day moving average. What we're looking at are large changes from day one to day two in the number of stocks trading above or below those envelopes.

Since 2003 (N = 915 trading days), we've had 45 occasions in which the change in number of stocks (NYSE, NASDAQ, ASE) trading above their envelopes has been 400 or greater. Three days later, SPY has been up by an average of .42% (30 up, 15 down). That is much stronger than the average three-day change of .12% (521 up, 394 down) for the entire sample. When we've had strong upthrusts since 2005 (N = 23), the next three days in SPY have averaged a gain of .29% (14 up, 9 down), also above average. These findings are similar to yesterday's: a strong upthrust tends to continue in the short term.

How about if we consider the reverse situation? What happens when a large number of stocks that *had been* trading above their 20-day MA envelopes now move back into their envelopes? Since 2003, that has occurred 41 times. Three days later, SPY has been up by an average of .43% (29 up, 12 down)--also much stronger than average. Since 2005 (N = 22), a large one-day drop in the number of stocks trading above their envelopes has led to an average three-day change in SPY of .35% (15 up, 7 down). These findings are also similar to yesterday's: a strong downthrust tends to reverse in the short-term.

Finally, consider what happens when we have very little change from one day to the next in the number of stocks trading above their envelopes. That has been the case in the recent market. Since 2003, there have been 172 occasions in which the change in number of stocks trading above their envelopes has been within a range of +50 to -50. We find no edge at all--bullish or bearish--going forward three days. The average change in SPY is .12% (94 up, 78 down). It does seem as though short-term directional edges are present at momentum extremes, not when markets are little changed.

My next post will follow up by looking at thrusts above and below the lower envelope of the 20-day moving average. I will begin formally tracking these thrusts daily in the Trading Psychology Weblog.

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