Tuesday, February 13, 2007

Weak Day in the Stock Market: What Comes Next?

In a recent post, I found that, in the trading session following a day of broad downside momentum, markets tend to take out that day's lows. That led me to short the market in early trade on Monday, which followed the historical scenario quite nicely. As it turns out, Monday also finished as a weak day in the stock market. By that, I mean that Monday: a) was a down day in the S&P 500 Index (SPY); b) closed in the bottom half of its daily range; and c) had a level of stocks making new 20-day highs minus new 20-day lows lower than the day previous.

Going back to 2004 (N = 776 trading days), I found 206 occasions meeting the above criteria of weakness. Out of those, we broke the prior day's lows on 131 occasions during the follow day of trade in SPY or nearly 2/3 of the time. Conversely, during the remainder of occasions in the sample (N = 570), we broke the prior day's lows 220 times, or about 40% of the time. This fits with the earlier research: weakness tends to follow through in the short run during the next trading session.

Once again, however, by the end of the next day's trading, that downside edge is lost: the market closes up 112 times and down on 94 occasions for an average gain of .05%--no bearish edge at all. Indeed, if we look three days out from a weak day, SPY averages a gain of .20% (123 up, 83 down), stronger than the average three-day gain of .07% (315 up, 255 down) for the remainder of the sample. What that means is that downside follow through after weakness has been very short term on average. Several days out, SPY has tended to rebound following such weakness.

These ideas will again inform my trading on Tuesday. By handicapping the odds of hitting key price levels--and determining the likelihood that moves will continue vs. reverse--we can develop a basic road map for the coming day's activity.