Tuesday, January 31, 2006

Broad Momentum Decline: What Comes Next?

Yesterday we saw that slow, narrow days lead to unfavorable expectations over the near term. Sure enough, today we saw a late drop today that could turn into a broad momentum decline tomorrow. A broad momentum decline, as I'm defining it, is one in which 500 or more stocks are displaying strong downward momentum as compared with upward momentum. Momentum is measured by a price close above or below a volatility band surrounding the stock's short-term moving average. All stocks in the NYSE and NASDAQ are included. When 500 or more stocks are closing below their envelopes than above, you have a large number of issues that are very weak in the near term.

Since March, 2003 (N = 724), we have had 42 broad momentum decline days. Two days later in SPY, the market was down by an average of -.11% (16 up, 26 down). After declining market days that did not show broad market declines (N = 271), the market was up two days later by an average of .18% (158 up, 113 down). What this suggests is that markets that fall without broad momentum tend to reverse in the short run, but markets with broad momentum declines tend to continue their weakness near term. This strikes me as a pattern worth exploring over a variety of time frames. If tomorrow turns out to be a broad momentum decline, we'd expect greater near-term weakness thereafter than if selling tomorrow is more modest.