Sunday, November 13, 2022

Strong Two Day Rally: What Comes Next?


We've seen stocks trade solidly higher for the past two trading sessions.  What has been notable about the move is not simply how strongly we've bounced, but the breadth of the rise.  Notably, we closed the week with over 80% of all SPX stocks trading above their 3, 5, 10, 20, and 50 day moving averages.  Think about what that means:  the great majority of shares are quite strong on multiple time levels.  This generally occurs when money managers and large institutional investors allocate more of their capital to equities as an asset class.  Such allocation is typically not a short-term, tactical decision.

My breadth database goes back to 2006, encompassing almost 4000 trading sessions.  Interestingly, over that period, we've only seen 45 occasions with over 80% of stocks closing above those moving averages.  Such breadth thrust is relatively rare.  Over the next few days, there has been no distinct directional edge, but we begin to detect momentum 20+ days out.  Specifically, over the next 50 trading sessions, the SPX has been up 39 times, down 6 times for an average gain of +3.41% vs. +1.95% for the remainder of the sample.

My preference is to measure breadth in multiple ways and look for occasions in which backtests line up.  On Thursday, we saw 854 stocks across the NYSE universe close above their upper Bollinger Bands.  That database goes back to 2019, and Thursday's reading was the highest over that period.  Since 2019, when we've had more than 400 stocks close above their upper bands (N = 13), the next 20 days were up 10 times, down 3, for an average gain of +2.72%, compared with an average gain of +.81% for the remainder of the sample.

To be sure, market history is no guarantee of the market's future, but we can find probabilistic edges by understanding the behavior of market participants.  When institutions are reallocating capital to stocks, it pays (on average) to swim with the current and not against it.  It is a big mistake to think that trading psychology is simply about our own psychology.  Some of the best edges, in trading as in poker, come from reading the psychology of those on the other side.

Further Reading: