Tuesday, September 15, 2009

Low Momentum Markets: The Dynamics of Ranges and Breakouts

One of my favorite measures of stock market momentum is a proprietary index of the number of stocks that close above (Demand) and below (Supply) the volatility envelopes surrounding their short-term moving averages. Since September, 2002, when I first began collecting these data, the average values for both Demand and Supply have been about 64, with a standard deviation of 40.

I generally think of a strong upside momentum as being 125 or greater in Demand; strong downside momentum as being 125 or greater in Supply.

Yesterday, both Demand and Supply closed the day below 50, which is a low reading. Indeed, of the 1757 days in my sample, this has only occurred 145 times. It indicates a low momentum market: relatively few stocks are closing above *or* below their volatility envelopes. That means they are closing closer to their moving averages, which in turn implies more range bound conditions.

Interestingly, when both Demand and Supply are less than 50, the standard deviation of returns over the next trading day is 2.47%. For the remainder of the sample, the standard deviation has been 1.26%.

What that tells us is that low momentum markets tend to lead to increased volatility over the short-term. This is due to breakout effects: traders caught long or short during a range market have to scramble to exit positions on a breakout and contribute to the magnitude of the subsequent move.

Ranges of X days, in and of themselves, don't necessarily predict the direction of any breakout over the next X days, but they do appear to be predictive of volatility of the next X day returns. That can be useful information for traders looking to anticipate market opportunity: intraday opportunity sets expand once breakouts occur.

Note : Demand and Supply are published daily before the market open via Twitter. Subscription to the Twitter feed is free and also includes links to articles reflecting important market themes; summaries of price targets for the day; and other indicator readings. More on Demand and Supply can be found here.