Sunday, January 07, 2007

DIA, The Diamonds ETF: What Happens After a Dow Reversal Week?

Past TraderFeed posts have focused on daily reversals in the S&P 500 (SPY) and the NASDAQ 100 (QQQQ) markets. During this past week shortened by the New Year's holiday and the day of closing to commemorate President Ford's passing, we had a downside reversal week in the Dow Jones 30 Industrial Average (DIA). By that, I mean that the week traded above the high of the previous week, but closed down for the week overall. Do we see any historical patterns with respect to such downside reversal weeks? I decided to go back to February, 1998 (N = 459 weekly periods) and take a look.

First off, let's take a look at what happens after a week in which we make a price high compared with the week previous (N = 257). One week later, the Dow averages a gain of only .03% (136 up, 121 down). Conversely, when the Dow fails to better its previous week's high (N = 202), the next week in the Dow averages a gain of .21% (114 up, 88 down). We thus see a mild tendency for stronger weeks to be followed by subnormal returns the following week and weaker weeks to be followed by better returns. This tendency has been somewhat more pronounced since 2004. When we've had a week that's made a higher high (N = 89), the next week in the Dow has averaged a loss of -.07% (41 up, 48 down).

Now let's break down those weeks in which we made a higher high into those occasions in which the Dow finished the week higher (N = 178) vs. finished the week lower (N = 79). Note that this latter group (traded above the previous week's high, but closed lower on the week) represents our downside reversal group. When the Dow has made a new high and closed higher, the next week in the Dow averaged a loss of -.04% (97 up, 81 down). When the Dow made a new high but reversed and closed lower on the week, the next week in the Dow averaged a gain of .21% (39 up, 40 down). In other words, the Dow was just as likely to close lower as higher one week after a reversal, but the average size of the gains was larger than the average size of the losses.

Interestingly, however, if we look out to *five* weeks following the Dow downside reversal, we see a more distinct pattern emerge. When the Dow has made a week-over-week price high and also has closed higher on the week, the next five weeks in the Dow have averaged a gain of only .04% (96 up, 82 down). When, however, the Dow has made a week-over-week high and reversed to close lower, the next five weeks in the Dow have averaged a gain of .94% (48 up, 31 down). By way of comparison, the average five-week change in the Dow over the entire sample has been a gain of .52% (268 up, 191 down). It thus appears that, if there is any tendency at all in the data, it is for downside reversal weeks to reverse over the coming weeks and display relative strength. We don't see any bearish edge to such a reversal, contrary to trader lore.

Ah, but wait. If we just focus on the time period from 2004 to the present, we find 31 occasions of downside weekly reversal in the Dow. One week later, the Dow averaged a *loss* of -.25% (12 up, 19 down). Interestingly, however, there was no downside edge on a five-week basis. Thus it seems that during the past three years, downside weekly reversals have tended to continue in the short run before themselves reversing. Indeed, 24 of the 31 reversal weeks traded below the lows of their reversal moves during the following week. Based on that view, a short-term or daytrader might consider starting the week out with a bearish leaning.

Still, there's one element missing from the above analyses. It's an important element, and it offers an important trading lesson that we need to consider with respect to historical market patterns. That missing element is context. Is the downside reversal occurring within the context of a larger market upmove or in a flat or downtrending market?

Since 2004, when we've had a downside reversal week that also made a five-week price high (N = 19), the next week averaged a loss of -.54% (6 up, 13 down). The following week traded below the low of the reversal week on 16 of the 19 occasions. Five weeks out, the Dow averaged a loss of -.44% (10 up, 9 down)--no evidence of reversal at all. By contrast, when the downside reversal week did not occur at a five-week high (N = 12), the next week in the Dow averaged a gain of .18% (6 up, 6 down) and a sizable average gain of 2.1% five weeks out (9 up, 3 down). We need to be careful because these are small samples. Still, they suggest that downside reversals that follow weeks of strength have not tended to bounce back and produce superior returns over the next several weeks.

What we find is that regimes shift over a period of years: the patterns of 2004-present are different from those of, say, the late 1990s. Moreover, the same exact price pattern may have different expectations depending upon the larger context in which it exists. The recent pattern of weakness following a weekly Dow downside reversal in a strong market is one that I will be keeping in mind for next week. Since 2004, weekly Dow reversals to the downside have indeed lived up to the trader lore and produced subnormal returns the following week.