Thursday, January 24, 2008

The CBI, Reversals, and Bear Market Rallies

Quite a day today. For those of you who “missed” the reversal – don’t sweat it. My studies indicate there’s plenty of upside left. Let’s first review and update things we’ve already looked at. Then I’ll show some new stats.

Capitulative Breadth Indicator (CBI)
The CBI remained at 13 today. It normally takes more than one day of buying to significantly reduce the number. The exit signal for this model will come when the CBI closes at 3 or lower. I’ve discussed it in great detail in the last several days. If you missed those posts and want to read up on it, just click the CBI label at the bottom of this post.

Time Stretch Study
Although I didn’t post this study until Sunday night, the study used Friday’s closing price as the presumed entry point. Amazingly, even with an entry as bad a Friday’s close, this study is currently 1% in the black.

Large Reversal Bar Study
The criteria for the reversal bar study on January 9th was the S&P 500 makes a 20-day low and closes greater than 1% higher on increased volume over the previous day. We met those criteria again today. While the Jan. 9th reversal bar ultimately failed, it wasn’t before opportunities for profit, or at least a scratch, made themselves available. Traders may want to go back and review that study and the subsequent trade management follow-up post as they both apply again today.

Large Bars Down and Up
What stood out over the last few days was the volatility and extremely wide range that the market traded in. I did a study looking at these two-bar reversals rather than just looking at the single bar reversal like above. Below are the results: (click table to enlarge)

All of the key stats here look pretty good. An average return of over 3% on a short-term index trade is always eye-catching. I also like the Win/Loss Ratios and Profit Factors (Profit Factor = Gross Profit / Gross Loss). There are fewer trades listed when the trades lasted more than 1 week because the setup occurred again a short time later and I didn’t want to double-count the stats for those instances. I’ve listed all the trades with a 5-day exit below.

A few notable things here:

1) All but one of these trades saw a pullback within the first five days. The lone holdout (9/11/98) pulled back below its entry price intraday on Day 6. Most of the pullbacks were 2% or more. As in the previous reversal bar study, this indicates it is likely unnecessary to chase an entry.

2) All of the instances led to a decent rally at some point beyond the five days shown. Five of the seven groups saw retests before their rallies. These were 10/87, 10/89, 9/98, 4/00, and 7-8/2002. The other two – 10/97 and 9/01 marked the bottom.

3) While the setup has occurred only ten times in the last 30 years, 3 of those times it happened within two weeks of a previous instance. The volatility experienced over the two-day reversal period did not dissipate quickly. This indicates the ride will likely remain a wild one.

Today was a good start. I believe in the days and perhaps weeks to come there is going to be more volatility and ultimately more upside. While I normally like to stick to the numbers in this blog, logically it makes sense to me that we get some upside here. Here’s my thought process. It seems the whole world is convinced we’re in a bear market. Most of what I see and hear is saying “sell into any rallies”. It is this disbelief which should help fuel to the rise. This may or may not be “the” bottom. If it is, then we will certainly see a nice rally. If it isn’t “the” bottom the rally should still be nice enough to suck in a good number of people before the next serious leg down begins. That’s what bear-market rallies do. They make believers out of suckers then take their money. In either case my studies indicate the rally should be strong enough to grab some profits. Just peek at the trades listed above – several of them were of the Bear Market Rally variety. So have we hit “the” bottom? I have no idea, but I’ll be re-evaluating all along the way.


High Plains Trader said...

Rob, not to pick but when you say several of those trades were of the bear market rally variety, that has to be because of your criteria in looking for the setup.

You said, "the S&P 500 makes a 20-day low and closes greater than 1% higher on increased volume over the previous day."

If you had chosen 20-day highs then your rallies would be of the bull market variety.

Again, excellent work.

Anonymous said...

excellent insight and analysis...

You were right on for the rally and calling for the worst hit (financials, HB) to produce the most upside.

Rob Hanna said...

I'm afraid I wasn't clear on the requirements for the "Large Bars Down & Up" study. There was no 20-day low required there. Only a 1% down day followed by a 2% up day with very large range each day (above 3.5%). The 20-day low was used in the Jan 9 Reversal Bar Study.

I suspect one reason that many of these showed up near lows is volatility near market bottoms is frequently higher. Not the case near tops.

Johan pointed out the the SPY didn't make a lower low yesterday while the SPX did. I normally use SPX for testing rather than SPY for 2 reasons 1) SPY has much less history and 2) SPY pays dividends which can mess up the chart. I agree that the fact that SPY didn't make a lower low muddles things a little bit, but I prefer not to make excuses or justify triggers - I normally just take them for what they say. If you prefer to discount the Jan. 9th study in this case - that's fine. The remaining studies are all telling me the same story, anyway.

Johan Lindén said...

Hi Rob!

I am a new reader of yours and just wanted to praise your blog!

Thanks for sharing valuable information with us!

Johan from Sweden

Johan Lindén said...
This comment has been removed by the author.
Johan Lindén said...

I just wanted to point that out. About the SPY I mean. And I agree with the two points you have made about the SPY. Although I feel that the divends payouts isn't important and valid in this case.

Your conclusion and analysis is probably correct anyway. I don't think the fact I pointed out would make a HUGE difference anyway.

Still the SPX opening call makes that index a little bit unreliable.

Anonymous said...

Have I got this right? Sample size of ten trades over 20 years for the 'large bars up and down'? My statistically based estimate predicts that you'll have enough data points to derive a minimally relevant stdev of returns in the year 2048.

Rob Hanna said...

Anonymous -

I actually ran the test back 30 years, but your point is well taken. You're correct if you're assuming a normal probability distribution and looking to calculate a Z-score off a minimum of 30 trades. Fortunately there are other ways to test for significance where we won't need to wait until 2048.

Thank you for bringing up an important concept. I'll be sure to discuss probabilities and significance testing in an upcoming post.


Anonymous said...

The SPY did not make a lower low on the 23.01.2008, but the SPX did. So far so good. But the SPX did not show a greater volume than the day before on the 23.01.2008, did it ?