Wednesday, February 18, 2009

Momentum Leads Price: What Happens After Strong Downside Momentum?

Long time readers of this blog are familiar with the proprietary indicator that I call Demand and Supply. It is my favorite measure of stock market momentum; the cumulative running total of Demand minus Supply is a staple of my weekly indicator updates and is my favorite overbought/oversold measure.

Demand is an index that captures the number of NYSE, NASDAQ, and ASE stocks that close above the volatility envelopes surrounding their short-term moving averages. Supply assesses the number of those issues closing below those envelopes. The idea is that stocks with strong upside or downside momentum will close outside their envelopes. By creating an index of the number of stocks with strong and weak momentum, we gain a sense for the momentum of the stock market as a whole.

As noted in this morning's Twitter post, Supply for Tuesday closed at a very elevated figure of 234. Since late 2002, when I began assembling these data, we've only had 21 occasions in which Supply has exceeded 200. Naturally, since this is an unusual event, I wanted to see if there was any edge going forward.

Interestingly, after such a weak day, the S&P 500 Index (SPY) opened higher 16 times and lower only 5 times for an average gain of .43%. Holding the weak market overnight in anticipation of further losses has not been a winning strategy.

When we look four days out, however, the average change in SPY following a very weak momentum day has been -.38% (8 up, 13 down). In other words, on average, the market lost all of its early bounce and then some.

What this suggests is that markets often will not bottom on very weak momentum. Rather, price will tend to move lower, even as a decline loses its momentum and eventually reverses. This is a dynamic that can set up trade ideas across multiple time frames. I will be elaborating this relationship between momentum and price with the resumption of my series of "Introduction to Trading" posts.