Friday, March 30, 2007

Fading The Herd: Five-Day Reversal Effects In The Stock Market

As noted in today's Trading Psychology Weblog entry, we made an intraday low in the major indices yesterday, but fewer stocks participated in the decline. We saw this drying up of participation in the reduced number of issues making fresh 20-day lows. We can also see that net closing five-day lows yesterday (red line in the above chart) were much reduced from the previous day's level. Indeed, we can see from the chart that, among the 40 S&P stocks that I follow that are evenly divided among eight sectors, we had 29 more five-day closing lows than five-day highs on Wednesday--considerable weakness.

So what happens after we have a session in which we have many net new five-day lows in the 40-stock basket? Going back to 2004 (N = 805 trading days), we've had 38 occasions in which those new lows have outnumbered new highs by 25 or more. Over the next five days in the S&P 500 Index (SPY), the market has gained an average of .74% (30 up, 8 down). For the remainder of the sample, the average five-day gain is only .12% (428 up, 339 down). What that tells us is that, when traders have been bailing out of stocks across a variety of sectors, that has been an excellent time to be a swing trade buyer.

And when we've had 25 or more net new five-day highs among stocks? The next five days in SPY (N = 32) have averaged a feeble gain of only .06% (16 up, 16 down). When traders have been buying up stocks across the sectors, returns have been subnormal.

It's a great example of how markets confound human nature. So much of trading success boils down to fading human sentiment.