Wednesday, November 01, 2006

What Happens After A Bearish Engulfing Pattern?

I notice that Brian Shannon, in his fine video review of the market, observed that Wednesday's action constituted a bearish engulfing pattern. Now I'm not exactly an expert on candlestick patterns, but the basic notion of a bearish engulfing pattern makes sense to me. We rise above the previous day's high, decline below the prior day's close, and close near the bottom of the day's range. On the face of it, that should be bearish, as we rejected higher prices. Brian notes that he doesn't put much stock in the pattern, preferring to focus on the longer time frame. In the end, as Victor Niederhoffer emphasizes, we must always do our counting and verify any conclusions with hard data.

I went back to 1996 in the S&P 500 Index (SPY; N = 2694 trading days) and found 45 occasions (like Wednesday) that met the following criteria: 1) today rose above yesterday's high; 2) today declined below yesterday's low; 3) today was the largest range of the past five trading sessions; and 4) today closed in the bottom 10% of its day's trading range.

Interestingly, the next trading day in SPY sports an average gain of .10% (31 up, 14 down), notably stronger than the average daily change of .04% (1405 up, 1289 down). Since 2004, we've only had 12 such bearish engulfing days, but--incredibly--11 of them have closed higher the following day for an average gain of .32%.

Clearly there is no next-day bearish edge to outside days that finish near their daily lows. Indeed, there has been a nice bullish tendency following such one-day declines. Once again, we find that anecdotal reasoning has its limits when it comes to market intelligence.