Two Consecutive Strong Momentum Days: What Next?

As regular readers know, I track a proprietary indicator called Demand and Supply as indicators of upside and downside momentum. These numbers are posted each morning before the market open via Twitter (follow here). Demand is an index of the number of NYSE, NASDAQ, and ASE issues that close above the volatility envelopes surrounding their short-term moving averages. Supply is an index of issues closing below those envelopes.

For the past two trading days, Demand has finished the day strong, indicating ongoing strong upside momentum among stocks. I went back to late 2002, when I first began collecting these data, and examined what has typically occurred in the S&P 500 Index (SPY) after two consecutive days of readings above 130. As a point of reference, the mean daily value for Supply over that period has been 644; the standard deviation has been 405. That means that a reading of 130 is more than 1.5 standard deviations above average--a strong reading.

Interestingly, this combination of strong days has only occurred on 18 occasions since late 2002. Over the next five days following this strength, SPY finished down by an average of -1.25% (6 up, 12 down). Indeed, from 1-5 days out, there was no bullish bias in the data. While this is a small sample, it suggests that assuming a continuing of short-term strength following high momentum is a mistake. It is common for markets to pause and correct after a rising tide has lifted boats for two straight days.
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