Clues The Market Character Could Be Changing

The market rose strongly on Thursday. NYSE advancers outpaced decliners by over 3 to 1 – the 2nd day in a row advancers accounted for over 70% of the total. I’ve noted a few times recently that rallies in the S&P 500 since the end of May have been quick to reverse. Most have not lasted more than 2 days before suffering a down day. There have been three 3-day rallies and none of four days or longer. The market has now closed up 3 days in a row. We are reaching the upper boundary of “normal”. Although I’m not betting on it, traders should be on alert for a change of character in the market.

The market may or may not pull back in the next day or two, but it appears likely to happen quite soon. Back to back days of 70% advancers are fairly rare. The fact that it happened without the S&P 500 posting a 10-day high is even more unusual. Since 1970 this has happened 20 times. Sixteen (80%) of the time the market closed below the close of the trigger day within the next four days. If you give it 10 days to work off the overbought breadth readings then 19 (95%) of the time you’d find a close lower than the trigger day. In other words, a pullback appears likely in the not-too distant future.

I believe one key to determining whether the market character is possibly changing and a new leg higher possibly beginning will be the action on this pullback. This is the 7th rally of 2-3 days since July 21st. The previous six saw a decline of at least 1.2% on the first day of the pullback. That’s not orderly and not really what you want to see. In fact, other than the July 21st 1-day mini-pullback the last “orderly” pullback that didn’t involve a sharp drop occurred on the last 3 days of April.

Seems to me it might be a good time to be thinking about taking some short exposure. If the pullback is orderly, you can flip to the long side. If the pullback is sharp like the rest have been, it could mean a nice, quick, short trade.

A Short System For Handling Chop

In my recent Trend vs. Chop series I showed how over the last 15 months or so the market has become more prone to chop and less prone to follow-through. Tonight I will show an incredibly simple system that would have fared exceptionally well over this time period. I’ll then discuss the possible value of such a system.

Entry Criteria:
1) The S&P 500 closes higher 2 days in a row AND
2) The S&P closes below its 200-day moving average then sell short on close.

Exit Criteria:
1) If the S&P closes under the entry price of the trade, cover on close OR
2) Cover on the close of day 4 if not profitable.

Time Period: 6/1/2007 – present

Results:

There have been 26 trades, 25 (96%) of which were profitable. The average trade made about 0.75%. They are listed below:



If you relax the entry criteria and don’t require the S&P to close below the 200ma, then there will be 43 trades – 41 (95%) of which were profitable.

Some thoughts:

Although the performance has been stellar over the last 15 months, this is not a great system. In fact, if you run performance back to 1960, it’s not even a winning system.

I’m not a fan of the exit criteria. It keeps winners small. With a little effort I’m sure traders could come up with a more profitable exit strategy – even if it meant suffering a few more losing trades.

The bottom line here is that the market has been especially choppy over the last 15 months. Once aware of this, traders should look to take advantage. Seeing the market move in one direction for even a couple of days should alert traders that they may want to take profits or consider a strategy to benefit from a swing in the opposite direction.

Lastly, this environment will certainly change. While the above system may not be a great “trading” system, it does appear to be a very useful “tracking” system. In other words, moves higher of 2 days or more have quickly reversed and provided the system a nice string of winning trades. Traders should be on alert for system failures, as they could be a sign that selling into up-moves may be falling out of favor and the market environment changing. Therefore they would need to adjust their approach to take advantage of the new, emerging environment.

Weak Bounce Is Not Encouraging

After the market suffers a sharp drop as it did Monday, the size of the bounce the next day can tell you a lot. A strong bounce may lead to further upside. Weak bounces often roll right back over. I plugged a 1.75% drop and a next day recovery of less than ¼ of the drop into the Wayback Machine tonight. Results below:



I have nothing good to say about these numbers, so I won’t say much.

Notable but not included in the table is that 77% of all instances closed lower at some point in the next three days. The average max drawdown for all trades over the first three days was just over 2.0%.

Bad Breadth & Volume Make Good Combo

Extremely negative breadth and extremely low volume is an unusual combination. On Monday we saw this combination. Below is a quick study which looks at it:



Not a huge edge, but it appears to suggest we should see a respite and a bounce sometime soon.

Trend Vs. Chop III - Weekly Bars

Last week I looked at trending vs. chopping tendencies for the market in both the daily and intraday timeframes. What I found is that in both time frames the market has evolved from trendy to choppy over time. Today I am going to look at weekly bars. I will also have some further follow-up later this week which look at the statistics of some of the “Trend vs. Chop” results.

I’m going to use the same “system” as last week to display weekly tendencies. The first test here buys on the close of any up bar and reverses to short at the close of any down bar. Like last week, the trades were at a constant $100,000 per trade for the entire period. No commissions or slippage are figured in to the test. A rising graph would indicate follow through is dominant while a falling graph would indicate reversals are dominant. Sideways action would suggest no tendency.


Unlike the daily and intraday time frames, which favored trendiness through much of their history until fairly recently, the weekly timeframe has been more prone to chop since the early 70’s.

As I did last week, let’s now break that down into upside follow-through and downside follow-through. You’ll see a large difference here. The chart below looks at the results of shorting down weeks.

In the bear market of the early 70’s this was profitable as the market tended to show persistent weakness. Since then, with the exception of a few short periods during bear markets, buying the dips has worked quite well.

Now let’s look at what happened if you looked to buy strength:

Upside follow through was strong through the 60’s and until January of 1973. That is where you see the peak near the left hand side of the graph. Since that time the market has gone through cycles that sometimes favored buying strength and sometimes favored selling strength. Thirty-five years later the equity of the system is right back near its peak 1973 level. It should be no surprise that the current spike down began in 2007.

These results shouldn’t come as much of a surprise to people who have spent time evaluating or developing swing-trading systems. When trying to take advantage of 3-5 day moves, it is generally easier to develop long-only strategies that perform relatively well over time than to produce short-only strategies that perform consistently well. Hence a big reason you see so many more long-only systems. Of course in 2008 so far shorting strength has been easier than buying weakness.

MarketSci's Take On Recent Studies

One relatively new blog I’ve begun to read and enjoy is MarketSci. Over the weekend I decided to check out some the past posts and studies on his blog. I was surpised to find one post eerily similar to my own Trend vs. Chop study that he published in July. Michael’s findings agreed with my own with some additional twists. He also looked at results above and below the 200-day moving average, and he looked at bonds as well.

I’ll be expanding the study again and publishing some results based on weekly bars a little later.

MarketSci also had an interesting post last week which expanded nicely on my recent SOX studies suggesting the SOX can act as a leading catalyst for the broad market.

Trend Vs. Chop For Intraday Traders

Yesterday’s post looked at the propensity of the market to chop vs. trend. The basic conclusion was that the market has shown less tendency to trend and more tendency to chop over the last few years. This was especially evident when looking at a long-term chart.

Today I’m going to show the tendencies on an intraday basis. The break down will be similar to yesterday. The first chart shows results of buying any up bar and then exiting on any down bar. 15 minute bars are used for all the tests below.
A rising graph would show a propensity to follow through and a falling graph would show a propensity to reverse. A flat graph wouldn’t favor either. One note about all these graphs is that the day is closed out flat. There is no overnight holding since we are only measuring intraday tendencies. Throughout most of the 90’s, the easiest way to make money intraday was to find an uptrend an jump on it. As with daily bars, that seems to have changed over the last several years.

What about shorting down bars? How has that worked?


Similar to buying strength, shorting weakness worked well in the 90’s. Over the last few years it has struggled. Even with the difficult stock market performance this year, downmoves have shown a higher propensity to reverse than to continue. The May-June period was a notable exception.

Now for the combination. The rules are basically the same as yesterday buy on an up bar and then reverse and short on a down bar. Again – no overnight holding since intraday trends are the issue.

No surprise here –trending behavior was favored until around 2003 when the market shifted to a significantly more choppy environment. The most pronounced choppiness has occurred in the last year and a half, suggesting the last year and a half has rewarded intraday reversal trades and punished intraday trend trades more than any time in the last 15 years.

Now for the long-term look back. For this test I was able to run the data back a little over 25 years.

As was seen with the daily bars yesterday, the propensity to reverse rather than trend is a relatively new phenomenon. Intraday traders would do well to consider the consequences of these tendencies when developing intraday strategies.

How To Trade The Choppiest Environment In 50 Years

If you trade trend or breakout strategies and have found the market difficult in the last year or so, I’m about to show a prime reason for that diffuclty. Below is a strategy that buys the S&P 500 on the close of any up day. The position is closed at the close of a down day. Essentially your looking to buy strength and sit out weakness.


This strategy worked well in the 90’s, but since the market topped in 2000, it has performed poorly. Since the Spring of 2007 it has really accelerated lower. What this means is that performance following up days has been especially bad. It suggests the environenment has been especially choppy. Whereas strength begat strength in the 90’s, it has led to immediate weakness since.

Now let’s take a look at downside follow through. In this case the strategy is to sell short on any down day and then cover on an up day.


This was a break-even strategy through July of 2002. Since then it has done terrible. Interestingly, it’s done especially bad over the last year plus. Even though the market has fallen precipitously, the manner in which it has occurred has made it difficult to profit if you’re trying to short breakdowns. Down days have been followed by up days.

What about a combination strategy? Buy strength and short weakness in anticipation of further follow through. Below is a chart with the combo strategy:

Again, since March 2007 this strategy would have experienced an incredible freefall.

Perhaps it would be best to take a step back, though. In the next chart I show back to 1960 instead of 1993 in an effort to find other periods where choppiness has been so prevalent.


As you can see, buying after strong days and selling after weak ones worked well for 40 years. In 2000 that changed, and the last year and a half is the worst it has ever been with regards to follow through. This would suggest that strategies that may have worked well for forty years or more could be suffering greatly now. Traders should consider the current choppy market behavior when designing strategies. Buying weakness and selling strength is working better than buying strength and selling weakness. They could also monitor charts like these to see if tendencies begin to revert back to pre-2000. If tendencies do revert, adjustments may be needed.
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Update: I just saw that Dr. Brett Steenbarger also addressed this topic in his blog today. He looked at it from an international standpoint as well. Click here to see his findings.
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Potential Bad Breadth Bounce On Tap

The selloff from Monday followed through on Tuesday. For the second day in a row declining stocks outpaced advancing stocks by nearly 3:1. Also notable is that even with 2 days of strong selling the S&P failed to close at a 10-day low. I ran these observations through the wayback machine tonight and came up with the following results:



Instances are a bit smaller than I typically like but the stats are impressive enough for me to take the study into consideration.

A few additional bits of information about the study:
1) 12 of 14 instances (85.7%) closed above the entry day close within the first week.
2) If you look out 7 trading days that improves to 13 of 14 (92.9%).
3) The average maximum gain over the next 12 days is 5.2%. The average maximum drawdown is 2.2%.
4) After 7-12 days the edge dissipates. The setup is only short-term in nature.

An Instance Where Light Volume Pullbacks Don't Provide Bullish Expectations

Normally light volume on a pullback can be regarded as a good thing. When the pullback is fairly large and the volume is extremely light the expectations can turn bearish. For instance, the S&P dropped about 1.5% today on the lightest volume since July 3rd. I loosened the parameters slightly to get a decent sized sample and ran a study:



Of course volume this week and next week are expected to be a bit lighter due to traders taking vacations. Still, I don’t find the results terribly encouraging for the bullish case over the next two weeks.

Nasdaq Showing Upside Persistence

The Nasdaq Composite has now closed higher 5 weeks in a row. In July we saw how negative persistence can be difficult to overcome. Now we have an example of positive persistence:



The kind of positive persistence we’re seeing often manages to continue higher over the following weeks and months.

Will strength in technology help to lift the market in the coming weeks, or will the negative influence of recent volume patterns lead to a move down? Should be interesting...

Exceptionally Low Volume Casts Shadow

The market bounced on Thursday, but volume was anemic. On the NYSE it was the lowest volume since the July 3rd holiday-shortened session. When the market moves up, you’d normally rather see it occur on strong volume. Exceptionally weak volume, like we saw today, has been followed by some difficult market conditions over the last 10 years. Some statistics below:



One additional thought on volume for the back half of August. Over the next two weeks it is probable that volume will drop off due to traders taking vacations. When monitoring volume, shorter-term comparisons may need to be made to gain value from the information. For example, rather than comparing volume to its 50-day average, you may get a truer indication by comparing it to the last 1-3 days.

SOX Bucks Selloff Again

The unusual strength in the SOX continues. I wrote about this last week. Tonight another example of how the market has performed when the SOX takes a leadership position. This time the comparison is to the SPX rather than the Nasdaq:

This is the 2nd time it has happened in a week. There have been only three other occurrences where the setup has triggered twice in a 1-week span. They were 4/10/96, 3/7/00, and 5/10/04 - all followed by nice rallies in the next few weeks.

A Look At Consecutive Up Days Over The Last Couple Of Months

The market made nice gains for the second day in a row today. Below is a recent chart of the S&P 500. Every time there were at least 2 up days in a row a purple dot appears.


In most cases over the last 2+ months 2 up days has quickly led to a selloff. The most the S&P gained on any 3rd day of this period was slightly over 2 points. A strong move higher could be a sign of a change in character for the market. Tuesday’s action may be worth noting. It could answer the question as to whether rallies will continue to be sold or whether they can start to accelerate their gains.

The Research Suggested This For Monday

Time for a shameless plug.

The Short-term outlook from the August 3rd Weekly Research Letter concluded:

“This would imply that weakness early in the week could be buyable for a swing trade.”

That weakness came on Monday the 4th and those who bought into it should have done quite well over the next few days.

In last night’s Weekly Research Letter I showed a study that triggered on Friday the 8th at the close. When this setup occurred the S&P 500 had posted gains the following day 14 times in a row. Today made it #15.

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Are Lagging New Highs Worrisome?

Even with the strong move to a new 30-day high on Friday new highs were unimpressive. In fact they were beneath new lows. I decided to examine the possible significance of this:



Results appear choppy and under perform a random sampling. The instances are quite small, and before jumping to conclusions it’s important to isolate the affect of the indicator. So below is the same test when news highs exceeded new lows:



These results are worse than the 1st case where lows exceeded highs. So while the market may pull back (which it frequently does after making 30-day highs), the blame shouldn’t be laid on the lagging number of new highs.

SOX Provides Bright Spot

On Tuesday the low put/call ratio and the reaction to the Fed suggested a pullback was likely to occur soon. Wednesday the volume pattern made the same suggestion. Thursday the market dropped hard. The S&P and Dow both lost almost 2%. The Nasdaq just under 1%. There’s no telling whether this drop will continue over the next few days, but for the bulls there is a silver lining in today's action: Semiconductors.

Today the semiconductor index (SOX) bucked the trend and rose over 1.5%. When semiconductors take on a leadership role, it’s normally a good thing for the market. I decided to look at times following other days where the SOX managed to rise over 1.5% while the Nasdaq dropped .75%:

Not only are the % wins and average trade columns notable here but the massive volatility as well. Look at the size of the average wins and losses when you go out 4-6 weeks. Even over the next two weeks they’re huge. If you’re bullish, the stats are compelling. If your unsure, then a volatility play might be something to consider.

Another Low Volume Example

I’ve showed before how light volume in a stongly rising market will often lead to a pullback. Wednesday’s market action set it up in a slightly different way. It does provide another nice example though.



Three bearish short-term studies all looking at different indicators the last two nights. Upside may be a bit limited over the next week or so.

Put/Call Ratio Hits 7-Month Low - What That's Meant

Normally I only post one study to the blog each day. Additional work is saved for Subscriber Letter recipients. But since August 6th is Independence Day in both Bolivia and Jamaica (as well as Ginger Spice’s birthday), I figured, “What the heck – let’s go for 2.”

The CBOE hit it lowest level since December 20th. That’s a quite a while. I checked to see what happened after other times it hit at least a 100-day low:



Score tonight Bears 2 – Bulls 0 (for the short-term).

Fed Day Spikes - Historical Aftermath

Last night’s study suggested a decent likelihood of a rise today based on the fact that the market was short-term oversold going into a Fed meeting. Today the rise came in a big way. So what happens after the market spikes up on the day of a Fed meeting? I ran a study:



While the SPX was up over 2% today, I used a 1% spike to ensure a decent amount of instances. More often than not the market tended to pull back over the next couple of weeks. While the downside edge isn’t huge on a percentage basis, the risk is quite a bit higher than the reward. Overall not encouraging for the bullish case over the next 2 weeks.

When The S&P Is Oversold Going Into A Fed Day

The S&P fell on Monday for the third consecutive day. There are some short-term price indicators reaching oversold levels at this point. More often than not, when the market goes into a Fed meeting and is short-term oversold, the result is a bounce. For tonight’s test I used the 2-period RSI. I looked at any time since 1978 the S&P 500 closed with a 2-period RSI reading below 20 the day before a scheduled Fed meeting. (I did not include unscheduled Fed meetings, since they all pretty much pop the market.) Summary results of all qualifying Fed days are shown below. They assume buying at the close the day before the Fed meeting and selling on the close the day of the Fed meeting. (Based on $100,000 per trade in the S&P cash index.):



Based on this, there appears to be a small edge to the upside for Tuesday.

More Detail On Put/Call Ratios

Last week I looked at some moving averages of the CBOE Put/Call ratio. I compared the 10-day average to the 200-day average. The 10-day average gives a sentiment snapshot for option traders. The ratios have risen gradually over the years as the market has evolved. The 200-day average helps to normalize the 10-day readings.

What was shown last week is that when the 10-period moving average is below the 200-period average, the market over time has lost money. When the 10-period moving average has been above the 200-period moving average, the net results over time have been a gain.

I decided this week to take a closer look. As it turns out, the results are not quite as cut and dry as they may appear at first. I used the same time period so that the numbers would match up. The column on the left shows the 10ma/200ma ratio. Returns are broken down by range. For example, on July 25th the 10-day average of the CBOE total put/call ratio was 0.96. The 200-day average was 1.03. Dividing the 10 (0.96) by the 200 (1.03) gives a result of about 0.93. Therefore, July 25th would have fallen into the 0.9 – 1.0 category. Points gained and lost are totals for the day following the reading.

I found these results quite interesting in a few ways. First, ratios just below 1 were bearish while times when the 10ma was strongly below the 200ma actually resulted in gains. I suspect this is due to the fact that the extremely low readings may be the result of a strong move to the upside. Strong moves up are more likely to continue up than weak ones.

Also interesting is the fact that 1.1 – 1.2 shows a negative return going forward. I suspect at this point the market may often be downtrending. Readings higher than this could signal exhaustion, which is why they results in positive days going forward.

An uptrending market with a little skepticism (1.0-1.1 reading) may be the sweet spot when looking for long-term gains.

While in general you'd rather see some skepticism with a ratio greater than 1, it’s not quite as simple as saying greater than 1 is good and less than 1 is bad.

Another Large, Low Volume Drop - Massive Edge or Statistical Anomaly?

The market has been on a roller coaster ride lately. It’s been six sessions since the initial bounce off the July lows topped out. In the last six days the S&P 500 has closed either up at least 1.25% or down at least 1.25% five times. Three times it’s been to the downside. All three times the big drops came on lower volume. As you might suspect, seeing the S&P drop 1.25% on lower volume 3 times in 6 days is a fairly rare event. Below is a summary of how the market has traded following such events:


The number of instances is too low to make much out of but the size of the returns is certainly eye-popping. An average return of over 5% in the next 7 sessions. That’s a substantial pop to say the least. For those who would like to review the dates, they are all listed below. Notice how 2002 dominated the study.


While not statistically significant, I find the results noteworthy and interesting. So to the header question: Are we looking at a massive edge or a statistical anomaly?

I'll let you decide.