Sunday, April 15, 2007

Money Flows in the Stock Market: Reversal or Continuation?

I recently posted on my use of momentum, strength, and sentiment data to assess whether markets are gaining or losing directional tendency. If there's a fourth leg to the table, it would be volume. In particular, I have been impressed by the relative dollar volume flow data and their ability to distinguish strong from weak markets. My recent post found that dollar volume flows into the Dow 30 industrial issues have been positive, although reduced from the strong levels of late 2006.

I'm reading a fair amount of bearish buzz on bulletin boards/forums and also hearing from bearishly inclined readers of the blog. While the sentiment is not quite as emo as after the late February drop, it does give me pause. What has me even more skeptical of the near-term bear case are those dollar volume flow data. The market corrections we've seen of late have been preceded by sustained periods of below-average dollar volume flows among the Dow stocks. We're not seeing that at present. Indeed, out of the last 20 trading sessions, fully 14 have seen above average dollar volume flows (i.e., daily flows greater than the 200 day average).

Let's take a look at the recent historical data. As of Friday, we're up over 3% on the Dow over the past 20 trading sessions. Going back to the start of 2005 (N = 553 trading days), we've had 74 occasions in which the Dow has been up more than 3% over a 20-day period. Ten days later, the Dow has averaged a gain of only -.02% (39 up, 38 down). By comparison, the average ten-day gain in the Dow over the entire sample period has been .29% (343 up, 210 down).

When we divide the strong Dow periods by dollar volume flows, however, a distinct pattern emerges. When the Dow has risen by more than 3% over twenty days and we've had solidly above average dollar volume flows, as we've had recently (N = 37), the next ten days in the Dow have averaged an impressive *gain* of .49% (27 up, 10 down). When the Dow has been similarly strong but we've had relatively weak dollar volume flows (N = 37), the next ten days have averaged a loss of -.53% (12 up, 25 down).

In short, rising markets with strong money flows have tended to continue their ascent. Rising markets with weak flows have tended to reverse. I will be investigating this pattern with other averages and over other time periods. For now, for me, it's a fly in the bear's ointment. Going forward, I'll update relative dollar volume flows for the Dow stocks in the Trading Psychology Weblog.