Wednesday, September 19, 2007

What Happens After A Strong Stock Market Rise?

Tuesday's market was quite strong, with advancing stocks trouncing losers on the heels of the Fed news. We saw some follow through buying today, but how do stocks fare in the intermediate term following a strong rise?

One measure I track is the number of stocks closing above and below the volatility envelopes surrounding their 20-day moving averages. All stocks trading on the NYSE, NASDAQ, and ASE are included in the calculation; my data go back to September, 2002 (N = 1244 trading days).

On Tuesday, the number of stocks closing above their volatility envelopes outnumbered those closing below their envelopes by a whopping 15:1. During the time I've collected these data, we've only had three higher readings: 6/29/06; 5/25/04; and 7/19/06.

In all, we've had 25 occasions in which the ratio has been 8:1 or greater in favor of stocks closing above their volatility envelopes. Of those, the S&P 500 Index was higher on 20 occasions over a three-week period for an average gain of .90%. That is moderately stronger than the average three-week gain for the remainder of the sample (.70%; 799 up, 434 down).

It's thus a mistake to assume that a strong rise is "due for a correction". 80% of the time, the market has been higher over a three-week horizon. As a rule, a market that lifts off with great strength tends to follow through in the same direction before undergoing a meaningful retracement.

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When Demand Swamps Supply

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