Thursday, April 12, 2007

Stock Market Momentum And Short-Term Price Cycles

In my most recent Trading Psychology Weblog entry, I describe the structure of short-term market cycles. This understanding is very important in framing hypotheses for the next day's trade, which is why the Weblog tracks market momentum and strength daily. While I appreciate the kind comments readers have given this blog, the most important day-to-day trading information I have to provide is actually on the Weblog.

To illustrate the relationship between stock market momentum and short-term cyclical behavior, I've summarized the S&P 500 futures market (ES) from March 13th to the present. Each daily price bar is accompanied by two numbers: that day's Demand reading (on top) and Supply reading (on bottom). Take a moment to study those numbers. You'll see an important pattern: Demand tends to top out ahead of price during rising markets; Supply tends to bottom out ahead of price during market declines. This provides us with a useful heads-up for swing changes in the market.

(Note: The H in the chart represents futures action during the market holiday when stocks were not open. The last bar in the chart represents pre-opening futures action for 4/12 before stocks began trading).

Demand and Supply, as I've noted in past posts, are indices that I construct to summarize the number of NYSE, NASDAQ, and ASE stocks that close above (Demand) and below (Supply) the volatility envelopes surrounding their short- and medium-term moving averages. To contribute to Demand, a stock must have strong upside momentum; to contribute to Supply, a stock must have strong downside momentum. Days in which Demand or Supply is strong tend to be trending days. Days in which Demand *and* Supply are low tend to be range bound days. When Demand or Supply is expanding, I look for the trend in place to continue. When Demand *and* Supply are waning, I look for consolidation. When Demand *and* Supply are very low, I look for a breakout move.

Bull swings lose momentum before they become bear swings.

Bear swings lose momentum before they become bull swings.

Broad momentum market moves tend to consolidate in momentum.

Low momentum markets yield breakout moves in the short run.

Because momentum generally peaks ahead of price, it pays to hold overnight following momentum breakouts, particularly to the upside.


If you watch diligently, you'll see these patterns replay themselves in different variations. You'll also see how these shorter-term cycles become nested within longer-term market trends.

Tomorrow, we'll take a similar look using new high/new low data in place of Demand and Supply and explore some of those longer-term trends.

10 comments:

Lauriston said...

"Demand tends to top out ahead of price during rising markets; Supply tends to bottom out ahead of price during market declines."

That observation is key to trading IMHO! Thanks for another insightful post!

Gary said...

where do you get your supply/demand numbers?

Brett Steenbarger, Ph.D. said...

Hi Lauriston,

Thanks for the note. There are many ways of tracking momentum and momentum shifts. Tracking a basket of stocks and assessing the % above a moving average or identifying the number making short term new highs or lows can work well.

Brett

Brett Steenbarger, Ph.D. said...

Hi Gary,

The Demand/Supply Index is something I developed to help me track broad market momentum. It's not available on any website or through any commercial service. I have to assemble it daily. But you can track the % of stocks above various moving averages through services such as Decision Point and StockCharts to get a good sense for whether momentum is rising or falling.

Brett

Jeff said...

Dr. Steenbarger, thank you for this interesting post. Do you think the Advance/Decline index could be used to that end and if so, how? If not, would you be able to give a pointer to the StockCharts page or service that's relevant? (I looked but couldn't find). Thanks again!

Brett Steenbarger, Ph.D. said...

Hi Jeff,

I've seen the charts for number of stocks above moving averages in Stock Charts, but don't use that service myself. The info is available from Decision Point, which is the service I subscribe to. I don't think advances/declines captures the same momentum info, though I haven't tested that.

Brett

Will Rahal said...

Hi BretT,
I have constructed a 5-day momentum indicator that plots
a normalized price change vs internal daily action of the market.At short term peaks the inernal action is significantle above the price change; at bottoms,
well below it
I just posted it on my blog
wrahal.blogspot.com

Brett Steenbarger, Ph.D. said...

Thanks for passing that along, Will; looks like an interesting site--

Brett

AnaTrader said...

Brett

Your say:
Bull swings lose momentum before they become bear swings.

Bear swings lose momentum before they become bull swings.

Broad momentum market moves tend to consolidate in momentum.

Low momentum markets yield breakout moves in the short run.
Unquote

I find the last especially - low momentum markets yield breakout moves in short run - a pattern to watch out for to have a good trade.

Brett Steenbarger, Ph.D. said...

Hi AnaTrader,

That pattern--very low Demand *and* very low Supply--has generally led to a breakout move over the next day or two. Worth keeping an eye on--

Brett