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.