Sunday, July 15, 2007

False Breakout or Fresh Bull Market Leg?

In a recent post, I noted that many indicators were not confirming the recent price strength in the large-cap stock indexes. Moreover, money flows in the Dow Industrial stocks have been weak, even as the market moved higher this week.

I just updated the Trading Psychology Weblog and present a more detailed look at the indicators, including an analysis of what happens in the market when a rise in the S&P 500 Index is accompanied by weak money flows in the S&P 500 stocks.

In the chart above, we can see that the market failed to expand the number of fresh 20-day highs minus lows among NYSE, NASDAQ, and ASE stocks during the recent rally. This further supports the view that the recent strength has been selective.

Indeed, if we look at advancing vs. declining stocks on a weekly basis for NYSE issues, we find that, last week, advancers outpaced declines by only about 200 issues despite the gain in the S&P 500 Index of over 1%. That is one of the weakest advance-decline performances for a market up 1+% since the start of 2004.

But what happens the following week when the S&P 500 (SPY) is up over 1% on weak advance-decline numbers?

Going back to the start of 2004 (N = 183 trading weeks), I found 55 occasions in which SPY was up more than 1% for the week. I performed a median split of the data based on advance-decline figures (% of issues traded that were advances minus declines). When SPY was up over 1% and advance-decline numbers were weak (N = 28), the next week in SPY averaged a loss of -.21% (13 up, 15 down). When SPY was up over 1% and advance-decline numbers were strong (N = 27), the next week in SPY averaged a gain of .14% (16 up, 11 down). For all other market occasions, the average weekly gain in SPY has been .28% (75 up, 53 down).

In short, weak rises tend yield subnormal returns going forward. This very much fits with my analysis of returns when money flows are weak, as posted to the Weblog. I will be watching the market carefully early in the week to see if the higher prices attract further buyers or if the market lives up to historical precedent and sees some profit taking--and a possible return to the prior trading range.