Thursday, March 22, 2007

Strong Upside Momentum In The Stock Market: What To Expect Next

Readers of the Trading Psychology Weblog are no doubt familiar with one of my favorite measures, which I call Demand and Supply. For this proprietary measure, I construct two sets of moving averages--one short-term, the other intermediate-term--and volatility envelopes around each of these. Demand is an index of the number of stocks that close above *both* envelopes; Supply is an index of the number of stocks that close below both envelopes. Accordingly, Demand and Supply capture both market breadth and market momentum. When Demand or Supply are very high, we know that we have a broad, high momentum move in the market.

My Demand and Supply data go back to mid-September, 2002 and cover all issues within the NYSE, ASE, and NASDAQ exchanges. Wednesday's rise on strong upside momentum provided us with a Demand reading of 226. That is the fourth strongest reading since that time. What this tells us is that buying interest in stocks has been extremely broad and strong over the past several days, a conclusion also supported by my dollar volume flow data.

A little while back, I mentioned a trading principle that has served me well: When we have expanding Demand or Supply, I expect a market move to continue in the short run. This is because momentum tends to peak or trough ahead of price. A while back, I applied this idea to a downside market. Let's see if this principle applies to the current strong reading in Demand.

Going back to September, 2002 (N = 1127 trading days), I found 11 occasions in which Demand exceeded a reading of 180. To provide a point of reference, this is a level at which stocks with significant upside momentum are outnumbering those with significant downside momentum by 8:1 or greater. When that has happened, the next day in the S&P 500 Index (SPY) has been up 6 times, down 5 times for an average loss of -.22%. By comparison, the average one-day gain for the market overall during the study period was +.04%. Certainly no bullish edge there.

When we look four days out, however, we see that the average gain following a very strong Demand reading is +.49% (9 up, 2 down). That is much stronger than the average four-day gain of .18% (632 up, 495 down).

If we broaden the Demand criteria and look at all occasions in which Demand has exceeded 150 (N = 32), we find quite a bullish edge four days out. Specifically, SPY has averaged a gain of .82% (27 up, 5 down). There is no bullish edge for the next day's trade, however.

What this suggests is that, in the very near term, strong upside momentum markets often take a bit of a breather before resuming their rise over the next several days. Accordingly, after strong and broad upside momentum, buying near-term weakness for a rise several days out has been a successful strategy.

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