IBD Follow Through Days pt. 1 - Are they predictive?

In my last entry I provided a quick overview of IBD Follow Through Days and posed a number of quantitative questions I intend to tackle. This will be the first installment in the series.

Since the market may be on the verge of providing investors with an IBD Follow Though Day I thought it best to tackle the most important question first. Are IBD Follow Through Days predictive of a new bull rally? If so what is the success rate? According to Investors Business Daily, Follow Through Days carry a success rate of between 70%-80%. To test this we need to first define some terms and make some assumptions:

1) What determines a “significant decline”? Declines can be determined many ways. Some may say it would require a series of lowers lows and lower highs. Others might say a certain amount of time should be involved. Others would simply look at a percentage drop to determine significance. I’m going to keep it simple and just look at percent drops. What percent is most appropriate is also arguable. For today’s test I chose 8%. In future studies I will look at multiple levels, so don’t worry if you don’t like my choice. There are two primary and subjective reasons I chose 8%. First, I wanted a number that wasn’t too small that I was testing every minor correction. A 5% drop could just be a few bad days so that seemed too small. Second, I didn’t want a number too large that IBD followers would tell me about all the great rallies my study missed. Since there weren’t any 10% declines in the S&P 500 from March 2003 through 2006, and Investors Business Daily published several Follow Through Day calls over that period of time, 10% seemed too large. I picked somewhere in the middle – 8%.

2) Investors Business Daily originally stated a Follow Through Day should be a rise of at least 1% in one of the major averages accompanied by an increase in volume over the previous day. A few years ago this number was changed to 1.7%. Their explanation was that volatility had increased in the market and a 1% move was no longer as significant. Whatever the reason I decided to test it both ways. As you’ll see, it made no difference.

3) For the test I used the S&P 500 as the “tradeable index”. Determination of success or failure was based on the movement in the S&P 500. I did this because of the three major indices (Dow 30, Nasdaq, and S&P 500), the S&P was the broadest and generally considered the most representative of the overall market. What should be noted, though, is that I allowed a Follow Through Day to be triggered by any of the three above listed major indices, as per William O’Neil’s definition.

4) Success and failure were the most difficult things to define. Here I wanted to be as liberal as possible to give Investors Business Daily the benefit of the doubt. IBD stated that failure could be defined by either “multiple signs of distribution – significant down days in higher volume” or “if one of the major indices undercuts its recent lows”. I was less stringent and said that the S&P 500 specifically would have to CLOSE below the INTRADAY low of the bottom prior to the Follow Through Day. (This decision incidentally made the 08/06/2002 Follow Through Day a success whereas most people would have labeled it a failure – and some the October 2002 bottom a failure.) Until that happened, it still had a chance to succeed. IBD has never offered a clear definition of success, so here I was on my own. I first decided that if you were going to use the Follow Through Day to make money then there should be a good portion of the move remaining. Therefore the target for success was set at twice the distance from the close of the Follow Through Day to the low of the potential bottom day. As hard as bottoms are to pick, I believe tops are even more difficult, so if you lose a third of the move off the bottom, you may also lose a third off the top. Therefore I wanted the meat of the move in the middle (potential reward) to be at least as much as the initial thrust (potential risk). There were a few instances where the market actually made new highs without fulfilling this requirement – so I made things even easier. I  said that any new 200-day high would also signal a “successful” Follow Through Day. This benefited several Follow Though Days. Instances that went from “failure” to “success” include the 08/11/1986 Follow Through Day and the 10/19/1989 Follow Through Day.

I ran the tests back to December of 1971. Since the Nasdaq began trading in 1971 and I wanted to include that as a possible trigger, it made 1971 a reasonable starting year. I needed about 200 bars of data to run some of the calculations and that is why the test only goes back to December of that year. While Investors Business Daily’s research undoubtedly goes back further, 37 years of data is plenty for me. Success or failure prior to that doesn’t concern me greatly.

The Results
I was unable to duplicate IBD’s success rate of 70%-80% even though I made the definitions of “success” and “failure” as liberal as I could.

Using a 1% upmove as the minimum thrust for a Follow Through Day, since December 1971 through January 11, 2008, 35 of 64 possible Follow Through Days were successful for a success rate of 54.7%.

Changing the minimum thrust from1% to1.7% as IBD has done in recent years resulted in 29 of 52 possible Follow Through Days being labeled “successful”. This equals a 55.7% success rate.

Rigging the definition of success to provide the IBD Follow Through Days the benefit of the doubt still didn’t allow me to approach their claims of 70%-80%. In fact the Follow Through Days would have been 50% or less accurate without my beneficial tweaks.

So back to the original question: Are IBD Follow Through Days predictive of a new bull rally? Well, somewhat. A coin flip is not exactly the kind of quantifiable edge I look for unless rewards are substantially higher than risks – which I will address in another post.

Are they as good as advertised? Not any way that I was able to find. Perhaps they’re running their tests differently than I. Unlike them though, I’m willing to back up my claims with some hard evidence (link to trades table).

In the coming days I’ll be answering many more of the questions I posed last night about Follow Through Days. By the time I reach the end of this series you should hopefully have a solid handle on what kind of quantifiable edge they really provide.