Sunday, July 02, 2006

An Unusually Sensitive Indicator--and What It Says Now

I recently posted on the topic of when Demand (the number of stocks displaying significant upside short- and intermediate-term momentum) exceeds Supply (the number of stocks displaying significant downside momentum on both timeframes). These figures, recall, represent an index computed from the number of operating company stocks that close above and below volatility envelopes surrounding two moving averages. The daily values are posted daily to the Trading Psychology Weblog.

I've noticed over the years that, by cumulating the daily difference between Demand and Supply, we obtain a very reliable overbought/oversold indicator. Since October, 2002 (N = 946 trading days), this index has varied between +57 and -36. The value of this cumulative Demand/Supply Index have correlated quite nicely with five-day returns in the S&P 500 Index (SPY).

After Thursday's sizable rally, we hit an overbought cumulative index value of +50. Since October, 2002, we've only had 20 daily readings of +50 or greater. Over the next five days, the S&P 500 Index has averaged a loss of -1.05% (!), with 3 occasions up, 17 down. That's about as sizable a downside edge as I've seen from an indicator.

Overall, when the cumulative Demand/Supply Index has been in negative territory (N = 208), the next five days in SPY have averaged a gain of .59% (126 up, 82 down). When the index has been in positive territory (N = 738), the next five days in SPY have averaged a gain of .10% (401 up, 337 down).

In general, readings above +40 have yielded meaningfully bearish returns; readings below -10 have been extremely bullish. The low for the recent downturn was -2 on 6/14; at the May peak on 5/5, we saw a reading of +55. I'll keep a close eye on this unusually sensitive indicator and report readings on the Trading Psychology Weblog and further research here.