Saturday, February 27, 2010

Stock Market Momentum and Price Cycles

The most sensitive indicator of stock market momentum that I've been able to develop is the measure of Demand and Supply that I post each morning prior to the market open via Twitter (follow here). Demand is an index that tracks the number of stocks that close above the volatility envelopes surrounding their short-term moving averages. Supply tracks the number of stocks closing below their volatility envelopes.

As a rule, Demand tends to peak ahead of price during market rises; Supply tends to bottom ahead of price during market declines. When Demand is rising and Supply is staying relatively low, we generally have uptrend conditions; when Demand is relatively low and Supply is rising, we usually have downtrend conditions. Range bound markets that are ready for breakout tend to occur when both Demand and Supply are well below average. (Click on above chart to illustrate some of these patterns).

I collect the data myself and archive each day in Excel. I've been doing that since late 2002. This gives me a large database that I can review; it also serves a practice function, as I walk through the data day by day and understand how upside and downside momentum shift during a market cycle. Doing that for years provides a feel that is difficult to achieve simply by watching canned indicators on the screen.

So what is the indicator saying? If this is a normal bullish bounce from the early February lows, we should see a move to two-week price highs on a rise in Demand that falls short of the high levels recorded on 2/16. That would be consistent with the pattern of Demand peaking ahead of price. Failure of Demand to stay above Supply this early in a cycle would be unusual and unusually bearish and would be expected to lead to a move below last week's lows.

By building scenarios with the indicator, I prepare myself for the coming week's market action. The best indicators serve logical and psychological functions.