Monday, July 06, 2009

When Markets Are Oversold Across Time Frames

7:34 PM CT - A reader kindly pointed out that not all of the conditions of the research below were met today, as we made a four day low, but not four consecutive lows in SPY. I believe the gist of the research is correct, but please take it with multiple grains of salt!

This morning's post discussed the value of historical research for perspective and gave an example that proved helpful during today's trade.

One key to doing historical research well is finding what makes the current market unique and distinctive, because--on average--that's where the greatest potential edges are to be found.

For example, we traded at a 20-day low today in the S&P 500 Index (SPY) and made a fourth consecutive lower low. This pattern has occurred 76 times since 2000. Two days later, SPY has averaged a sizable gain of 1.03% (53 occasions up, 23 down). By contrast, the average two-day gain for SPY for the remainder of the sample has been -.05% (1157 up, 1134 down).

What that suggests is that, on average, markets that have been weak in the short-term (four days lower lows) *and* weak on an intermediate term (20-day lows) have tended to bounce in the short term. That can then become a hypothesis for subsequent trading, and we can see if market action is supporting or disconfirming the hypothesis.

Either scenario provides useful information: whether a market is living up to its historical script or whether it's doing something different gives us useful information about how we're trading. (Hint: A historical look suggests that it's the markets that are weakest that fail to sustain bounces in oversold conditions.)