Tuesday, February 06, 2007

Consecutive Narrow Days: What Comes Next

We've had three consecutive days in which the high-low range in the S&P 500 Index (SPY) has been well under the average range for the prior 20 trading sessions. In all, the average range of the three days has been less than 60% of the 20-day average range. Clearly this represents a kind of consolidation. What tends to follow when we get such a protracted period of narrow trading?

Going back to 2004 (N = 773 trading days), I found 81 periods in which the average three-day range was less than 70% of the average 20-day range. Four days later, SPY averaged a loss of -.01% (41 up, 40 down). That is weaker than the average four-day gain of .15% (395 up, 297 down) for the remainder of the sample.

When, however, we break down the sample of narrow periods by their prior 20-day price performance, a pattern emerges. When the narrow period follows 20 days of an up market (N = 67), the next four days in SPY average a loss of -.17% (30 up, 37 down). Conversely, when the prior 20 days have been down in price (N = 14), the narrow period was followed by an average four-day gain of .82% (11 up, 3 down). In other words, when a narrow period has followed 20 days of strength, it has tended to be part of a corrective process that has lasted several more days. When the narrow period has followed 20 days of weakness, it has tended to be followed by a price reversal. We might say, then, that these narrow periods have tended, on average, to be periods of short-term market transition.

I note that we had 26 narrow periods in the S&P 500 Index during 2006; 19 of these were lower four days later. While this by no means indicates a likely bear market, it does suggest modest expectations for the remainder of this week.