Thursday, February 02, 2006

Large Decline & A Five Day Low

Thursday's decline came very close to one of those strong momentum declines that we recently explored, and that would have us looking for more downside. The key 500 difference between stocks with extreme negative momentum and those with extreme positive momentum, however, was not quite reached. As a result, I tried a different analysis: What happens after the market, like Thursday, declines by more than 1% and closes at a five-day low?

Since the bull market began in 2003 (N = 728), we've had 55 days in which the market has dropped more than 1% and closed at a five-day low. Three days later, the market averaged a gain of .36% (35 up, 20 down), much better than the average three-day gain for the remainder of the sample (.17%; 396 up, 277 down). This finding of superior returns after X-day lows is similar to the findings from Larry Connors in his book "How Markets Really Work". Unlike strong momentum declines, which tend to persist in the short run, extended declines tend to reverse.