Saturday, July 04, 2009

Sentiment Cycles in the Stock Market

The recent post on market momentum and Demand/Supply reflects part of a larger conceptual framework that has served me well over years of trading. The theory is that the stock market moves in aperiodic cycles in which momentum extremes tend to precede price highs and lows. I will be covering this topic in greater detail during the summer seminar in Chicago and in subsequent webinar events.

Any good theory should lead to fresh, testable observations. Much of my proprietary research follows from basic notions of sentiment cycles. From this research, we can gain trading insights, but can also make fresh observations to refine theoretical understandings. I am firmly in the camp of psychologist Kurt Lewin, who noted that "there is nothing so practical as a good theory."

Take Thursday's breakout to the downside and market selloff, for example. Supply greatly exceeded Demand on the day, reaching an extreme above 200. If momentum extremes tend to precede price extremes, we should tend to see lower prices following such an elevated Supply reading.

Going back to late 2002, when I first began calculating the indicator, we have had 32 instances in which Supply has exceeded 190. Looking out three days, the market has traded below its low of that day on 29 of these 32 occurrences--nearly 90% of the time. That is quite a bit more often than the roughly 60% of the time we get lower lows after three days for the remainder of the sample.

Knowing this can help set up valuable swing trades, particularly if we utilize good intraday trading/timing to achieve a favorable risk/reward profile for the trade and integrate historical patterns across different time frames.

4:13 PM CT - Quick addendum to the post. If we look at occasions in which Demand is less than 20 and Supply is greater than 100, we find that such skewed downside momentum also leads to lower prices over the short run, with 39 of 42 occasions trading below the low of the momentum day within a three-day horizon.