Friday, October 19, 2007

Big Down Day in the Stock Market: What Comes Next?

Well, it started with divergences in our indicators last week and then picked up with a repeat of the risk aversion trade from August, as noted in the Twitter comments. Friday's market truly accelerated the weakness: we saw 456 new 20-day highs across the major exchanges and 1805 new lows. The downside momentum was evident in the Demand/Supply data, with Demand (an index of the number of stocks closing above the volatility envelopes surrounding their short- and intermediate-term moving averages) at 21 and Supply (those closing below the envelopes) at 204.

I went back to the start of 2003 (N = 1185 trading days) and found 22 occasions in which we had more than 1000 new 20-day lows and Supply greater than 150. These, like Friday, are days in which we have seen high downside momentum, with a number of stocks extended to the downside.

Interestingly, of the 22 occasions, 16 registered a lower daily close in the S&P 500 Index (SPY) during the next week of trading. Indeed, five days after the strong momentum down day, SPY was up 11 times and down 11 times, for an average loss of -.14%. That compares poorly with the average five-day gain of .23% for the remainder of the sample.

In sum, broad weakness and downside momentum are often followed by further price weakness in the short run. It's when index lows occur with fewer stocks making fresh price lows on less extreme downside momentum readings that reversals are most likely to occur.


Stock Market Momentum and Short-Term Price Cycles