Wednesday, February 17, 2010

What Happens After Strong Stock Market Breakouts?

Yesterday we saw my proprietary measure of Demand exceed Supply by a greater than 10:1 ratio. (Note: I post Demand and Supply scores each morning before the open via Twitter; follow the tweets here).

Recall that Demand is an index of the number of stocks across the major indexes that have closed above the volatility envelopes surrounding their moving averages. Supply is an index of the number of stocks closing below those envelopes.

When we get a large plurality of stocks trading above their envelopes and very few below (as happened yesterday), it generally signifies a broad breakout move to the upside. What has happened historically following such a move?

I went back to the start of my database in late 2002 and found 30 occasions in which Demand exceeded Supply by a ratio of 10:1 or greater. Five days later, the S&P 500 Index (SPY) was down by an average -.67% (15 up, 15 down). By contrast, for the remainder of the sample, SPY was up on a five-day basis by an average of .12% (1008 up, 810 down).

In other words, it is common for upside breakout moves to take a breather over the next week. The exceptions would be unusually strong markets coming off intermediate and long-term lows, as very nicely explained and illustrated today in the excellent SentimenTrader service.

Knowing the market's "script"--how it has tended to behave historically--gives us a nice benchmark by which to assess upcoming market action. It's when markets don't do what they are "supposed" to do that we often can find meaningful opportunity.