High Momentum Stock Market Declines: What Comes Next

My recent post took a look at what typically follows a single day of large price declines. Here is a very different take on near-term prospects following a high momentum decline. Recall that one of my core trading principles is that a trending move with strong momentum tends to persist in the short run. Let's see if that might apply to the current market.

My best measure of stock momentum is the proprietary Demand/Supply index that I track daily on the Trading Psychology Weblog. Demand, you might recall, is an index of the number of stocks closing above the volatility envelopes surrounding their short- and intermediate-term moving averages. Supply is a similar index, tracking the number of issues closing below the volatility envelopes surrounding both their moving averages.

Demand and Supply follow every operating company trading on the NYSE, NASDAQ, and ASE. They tell you the relative number of issues closing either very strong or very weak in the equity markets. I have collected the Supply and Demand data since September, 2002. Tuesday's market hit the highest level of Supply recorded over that period: 420. We have only had seven other days with Supply levels above 200. The next day in SPY, five of the seven days finished lower in price, by an average of -.38%. Five days later, six of the seven occasions finished lower, by an average of -1.06%. These are much weaker results than the average market performance over that period.

Of the seven sessions in which we had very strong downside momentum, six traded below their day's lows during the following session. Indeed, four of the seven broke those lows by more than ten full ES points. Weakness, then, tends to carry over to the next day following a high momentum decline.

Interestingly, when we had days in which downside momentum was strong but not extreme (Supply greater than 1500, but less than 2000; N = 24), the next five days in SPY averaged a healthy gain of .67% (15 up, 9 down). By contrast, the average five-day gain over the entire period was .24%.

In sum, when we have large declines on downside momentum that is extremely broad--as we had Tuesday--we tend to see followthrough to the downside over the short term. When large declines are not so extreme in the breadth of their negative momentum, we tend to see reversals over the short term. It is for this reason, in spite of the small sample size from my data, that I will be open to selling strength early on Wednesday in anticipation of breaking Tuesday's lows. Note, however, that as I'm writing, we have bounced significantly higher in the overnight stock index futures. A recent comment on my previous post from Trading Nerd took the data back to 1930 (!) and found evidence of positive returns after a 3% decline, but that most of those occurred the next trading day. Such a pattern--sharp bounce, then some follow through decline--would help to connect the results from my previous post and this one.

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