Wednesday, April 04, 2007

What Happens After A Surge In New Highs?

Let's revisit a post from a few days ago in which we took a look at the number of stocks making five-day closing highs. That post focused on reversal effects after we see a large number of stocks making new lows. Indeed, we have gotten just such a reversal. Now, however, we have a situation in which we saw a surge of new highs on Tuesday. What can we expect going forward?

Recall that we're looking at a basket of 40 S&P 500 stocks divided evenly among eight sectors. These sectors include Materials, Industrials, Consumer Discretionary, Consumer Staples, Energy, Health Care, Financial, and Technology stocks. When we see a large number of these stocks simultaneously making new highs, it means that we have market strength that extends across these sectors.

Going back to 2004 (N = 813 trading days), we've had 35 occasions in which we've had 25 or more net new highs within the basket on a given day. (Tuesday's level was 25). We'll call that the strong day. The next day's high exceeds the high of the strong day on 23 of those 35 occasions by an average of .23%. If we look three days out, the high of that day exceeds the high of the strong day on 27 of the 35 occasions, by an average of .45%. By contrast, the high three days out exceeds the current high by only .09% (465 up, 348 down) for the entire sample.

If we look on a close to close basis, we find out that, three days later, we close higher than the strong day on 23 of the 35 occasions, with an average gain of .26%. By contrast, the average three-day gain for the entire sample is only .09% (454 up, 359 down).

What this is clearly telling us is that, after a broad market rise, the market tends to drift higher over the next three trading sessions. Strength begets strength, near term. As I mention in my most recent Weblog entry, it makes sense, when you get a broad-based breakout move, not only to hold to the close, but to leave at least a piece on for further strength.

When we extend the look to five days out, however, a different picture emerges. Five days after the strong day, the market closes higher 18 times and lower 17 times, for an average gain of .12%. For the sample overall, the average five-day gain is .16% (462 up, 351 down). In other words, we lose any bullish edge after a strong day if we hold beyond three trading sessions.

This is a common market pattern. Very strong upside markets tend to produce further strength in the near term, but tend to reverse subsequently. Knowing these patterns can aid you in setting profit targets and maximizing profits on breakout trades. Knowing the patterns can also help daytraders frame their trading ideas, as they will want to think about buying dips immediately following surges in new highs. Knowing historical odds is no guarantee of market profits, but trading in ignorance of the odds is an unattractive alternative.