Saturday, January 05, 2008

Herd Behavior in Markets: When Down Volume Swamps Up Volume

One way of assessing the bearishness of market participants is by examining the ratio of down volume to up volume. This tells us how much volume is concentrated in stocks moving lower in price vs. those moving higher. When large market participants dominate the sell side, as they did on Friday, the ratio of down volume to up volume becomes quite skewed.

I went back to the start of 1990 (N = 4535 trading days) and examined all occasions in which 85% or more of the directional volume was down volume. Interestingly, only 132 days met this very bearish criterion. Three days later, the S&P 500 Index ($SPX) was up by an average of .51% (79 up, 53 down), much stronger than the average three-day gain of .10% (2429 up, 1974 down).

Perhaps the most interesting finding, however, is that 25 of the 132 very bearish days occurred in 2007 alone! Three days later, $SPX has averaged a gain of .61% (16 up, 9 down). What we're finding is an increased tendency of the stock market to move in herds. Out of the 132 bearish days since 1990, 53--about 40%--have occurred since 2003. I believe this herd dynamic helps explain why intraday trading strategies such as Rennie Yang's trend catcher have been so successful. There is something of a bullish short-term bias following highly bearish days, but while you're in the middle of such a day, it pays to not fight the market.


Fading the Herd

Directionality and the Herd

Herding Sentiment in the Stock Market