Sunday, March 20, 2016

A Different View Of Stock Market Strength And Weakness

Sometimes, an important indication of market strength is the absence of weakness.

An interesting example comes from the Stockspotter site, which offers cycle-based forecasts for stocks and ETFs.  I've tracked the cumulative number of buy and sell signals from the site since late 2013.  When there have been fewer than 10 sell signals on a given day (N = 225), the next ten days in SPY have averaged a gain of +.47%.  When there have been more than 10 sell signals on a given day (N = 317), the next ten days have averaged a loss of -.06%.  Interestingly, when there were few sell signals, the number of buy signals didn't matter.  It was the absence of weakness that was most important.

Another notable example comes from the Stock Charts site, where I've tracked buy and sell signals from technical systems for all NYSE stocks going back to mid-2014.  When we've had few sell signals in the Bollinger Band indicator, based on a median split of the data, the next 20 days in SPY have averaged a gain of +.43%.  When we've had a high number of sell signals based on the median split, the next 20 days have averaged a loss of -.14%.  In this case, the number of buy signals *did* matter; superior gains have come from having many buy signals and few sells.

Still a different pattern emerged when I tracked the number of stocks across all exchanges making fresh one-month lows.  (Data from the Barchart site).  Based on a quartile split of the data from mid 2010, when I first began archiving these data, returns over a 10-day horizon were superior when there were few new lows (bottom quartile; average SPY gain of +.60%) and also when there were many new lows (top quartile; average gain of +.81%).  All other occasions averaged a gain of only +.18%.

The takeaway here is that strength and weakness are not necessarily flip sides of the same coin.  Momentum and mean reversion effects are the results of interplays between strength and weakness, such that the absence of strength or the absence of weakness themselves become meaningful measures.  I believe this can be explained by the dynamics of market cycles, which themselves are the result of high strength/low weakness giving way to high strength/high weakness and then low strength/high weakness and low strength/low weakness.  

Across multiple measures, the recent market rise has been one of low weakness.  Those expecting mean reversion have been sorely disappointed.  There is more to market behavior than mere "overbought" and "oversold"--and dissecting strength vs. weakness is one way to identify where we're at in market cycles.

Further Reading:   Finding Opportunity in Market Cycles