Sunday, May 03, 2009

A Short-Term Look at Stock Market Strength and Momentum

The recent post introduced a measure of market strength based upon the market's ability to hit volatility-adjusted price targets. A key idea from the prior post in the series is that momentum tends to precede price: we will see some moderation of price rises/declines as markets top/bottom. The Strength measure is promising, because it assesses the significance of the market's movement from open to close based upon the overall volatility occurring at the time. Thus, the odds of the market making a big +4 rise or -4 decline are the same in a low VIX environment and a high one.

Above is a five-day moving average of Strength (pink line) plotted against daily SPY closes for 2009. We can see how Strength bottomed ahead of price earlier this year; also we can see how the market's current rise has been sustaining strength, but waning over time.

If volatility is expanding as markets move directionally, we will get very high Strength readings. If markets are moving directionally but on waning volatility, the Strength readings will moderate. As falling markets attract buyers and rising markets attract sellers, it becomes difficult to sustain those moves to R2/S2 and R3/S3. In upcoming posts in this series, I will further refine the ways we can exploit this relationship.

I will also be posting 5-day strength readings as part of my preopening Twitter briefings, which summarize daily readings for the indicators I follow most closely, including new 20-day highs/lows; Demand/Supply; and the number of stocks in my basket that are uptrending, neutral, and downtrending. Subscription to the Twitter feed is free of charge or you can pick off the last five tweets on the blog page under "Twitter Trader".