Saturday, December 22, 2007

Returns Following Surges in New Lows

In the last post, we looked at returns in the S&P 500 Index following surges in the number of stocks making short-term highs. Now we'll look at surges in the number of stocks making new short-term lows and see if those affect returns over 5 and 20-day horizons.

Going back to 2004 (N = 981 trading days), we have 55 occasions in which the net number of new five-day lows minus new highs among the 40 stocks in my basket has been 25 or greater. Five days later, the S&P 500 Index (SPY) is up by an average of .86% (42 up, 13 down)--much stronger than the average five-day gain of .10% (513 up, 413 down).

When we look 20 days out, we see continued outperformance following surges in the number of stocks making new five-day lows. Twenty days later, the average gain in SPY is a very healthy 2.04% (45 up, 10 down), much stronger than the average 20-day gain of .48% (581 up, 345 down) for the remainder of the sample.

This makes conceptual sense. When traders panic and sell stocks indiscriminately across sectors, this marks a period of maximum bearishness. With no more bears available to sell, short-covering aids value-oriented buyers and we see favorable prospective returns.

Putting together the findings from this post and the last one, we can see that, on a 20-day horizon, returns have been best when a plurality of stocks are simultaneously making new highs or new lows. When they are making fresh highs, momentum tends to carry them further before there is a major correction. When they're making fresh lows, reversal effects occur more quickly--at five and 20-day horizons.

Understanding these patterns helps short-term traders make decisions regarding trading vs. fading market strength and weakness.


Falling Markets and New Lows

When New Lows are High