Sunday, May 18, 2008

Market Strength: When Do Strong Markets Trend Higher?

I have to credit Henry Carstens, a master system developer, for this line of research. If you're not familiar with Henry's work, check out his creative system for providing an "all clear" signal following a spike in VIX. He also has a free e-book that is an introduction to testing trading ideas and a larger volume for sale at a modest price that goes into greater detail. Excellent resources.

Henry emailed me yesterday with an idea for a system that would predict trending behavior in a bullish market environment. In other words, it would capture when a rising market is likely to continue rising.

I took Henry's line of reasoning and adapted it to the historical indicators that I collect. Specifically, I went back to 2004 (N = 1101 trading days) and took a look at an indicator that I will call Market Strength. Market Strength is one way to assess the relative proportion of stocks that meet an upside momentum criterion.

When the S&P 500 Index (SPY) is up on the day (N = 577), the odds of the next day closing higher in price has been 51%. Pretty much tossing a coin.

When the S&P 500 Index is up on the day and Market Strength is above average (a simple median split of the data; N = 288), the odds of the next day closing higher in price is 57%. When the S&P 500 Index is up on the day and Market Strength is below average (N = 289), the odds of the next day closing higher in price is 45%.

Perhaps even more interesting, the odds of getting an up day following an up day appears to be directly related to Market Strength. When we have a very strong Market Strength reading (N = 52), the odds of the next day closing higher rise to 66%.

While Market Strength will remain a proprietary measure for now, I will be refining this line of inquiry and eventually incorporating into my blog posts and Twitter comments so that traders might benefit from the historical research. Hats off to Henry and to all those who express their passion for markets through original research and who fertilize their efforts by sharing with other researchers.

RELATED POSTS:

Market Strength and Short-Term Price Cycles

Momentum and NYSE TICK

The Importance of Participation
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