Friday, July 03, 2009

Demand and Supply: A Look at Bullish and Bearish Stock Market Momentum

If you click on the chart, you'll see a 60-minute rendering of the S&P 500 e-mini (ES) futures. Note the numbers above each date in blue. The top number is Demand (a proprietary index of the number of NYSE, NASDAQ, and ASE stocks closing above the volatility envelopes surrounding their short-term moving averages); the bottom number is Supply (an index of the number of stocks closing below their volatility envelopes). I make this numbers available each morning prior to the market open via Twitter; you can follow the tweets here.

Demand/Supply acts as a momentum indicator. During the early portion of a short-term uptrend, many stocks will close above their envelopes. As the rally loses steam, we'll see momentum wane, though Demand will still exceed Supply. Once we begin to top out, we'll see Supply pull ahead of Demand and relatively low Demand and Supply numbers, as few stocks show significant momentum. As the bears take charge, we'll then see the early portion of a short-term downtrend and many stocks will close below their envelopes. The decline will lose steam as momentum wanes, though Supply will still exceed Demand. Then we start the cycle all over again.

Note how the downside momentum petered out around the 23rd of June, leading to strong upside momentum on the 25th and 26th. We then began to lose momentum, and yesterday's decline started us on the high momentum side of a short-term decline.

As you would expect, in longer-term uptrends, we'll see Demand peaks at higher highs and Supply peaks at higher lows. In longer-term downtrends, we'll see the reverse. In range markets, we'll see the peaks and valleys in Demand and Supply occur at similar high and low price levels, respectively. As a rule, higher price highs and lower price lows that occur on weaker Demand or Supply are more vulnerable to reversal than higher highs and lower lows that occur on expanded upside or downside momentum.

By tracking these numbers daily via Twitter, you can gain a feel for whether a market is accelerating in a trend, decelerating, or stalled out. That's useful in anticipating scenarios for the next day's trade. Should we see downside momentum wane at or above the June lows on the chart, that would provide us with a strong indication of a range market (and set us up for an eventual buy as momentum turns to the bull side). Continued high levels of Supply at price levels that take out the June lows on the chart would clearly give us a longer-term bearish trend--and more serious correction to the bull market.