More Evidence Suggesting A Short-Term Pullback And Implications If It Doesn't

Last night I showed a couple of studies that suggested the market was likely to begin a pullback or at least a consolidation in the next few days. Tonight I’ll review and remake some past studies.

Tuesday was an inside day for the S&P 500. (Lower high and higher low on the chart.) On February 10th, I discussed inside days with down closes. Tuesday closed higher so it didn’t quite qualify under that study. Looking at all inside days in SPY going back to the beginning of 2001 I uncovered the following:

There have been 215 inside days in SPY since 1/1/2001.
116 times (54%) the market closed LOWER the next day.
The average loss the next day was 0.9%.
The average gain the next day was 0.6%.
The net average move the next day was a 0.2% loss.

I then looked at inside days when the market had made a short-term move up and was at or approaching overbought. For this I required the 3-period RSI to be 70 or greater. This led to the following results:

There have been 48 inside days in SPY since 1/1/2001 with the 3-period RSI closing above 70.
29 times (60%) the market closed LOWER the next day.
The average loss the next day was 0.55%.
The average gain the next day was 0.37%.
The net average move the next day was a 0.2% loss.

The second concept I discussed recently which is once again popping up is consecutive higher closes in a long-term downtrend. Below are the results of selling short the SPY any time it closes higher 3 days in a row while under its 200 day moving average.

More and more evidence is starting to point at a likely pullback. Still, caution is warranted. The market just posted a Follow Through Day. Past Follow Through Days have also typically led to short-term overbought conditions. This did not lead to a downside edge over the short-term. Readers may want to review my Feb. 1st column for more details on this. Also in the Feb. 1st column I show how the first week following a Follow Through Day has predicted the success or failure of the rally about 2/3 of the time. Traders may want to keep this in mind and pay special attention to the action over the next few days.

In short, a pullback now appears more likely than not. Should the market fail to pull back over the next few days that would suggest positive implications for the intermediate-term.

Inside Days

Wednesday the market posted an inside day. I haven't discussed inside days in a while. For those unfamiliar an inside day is simply a day that makes a lower high and a higher low than the day before. Over the last decade, when the market has been trading below the 200ma, inside days have suggested negative short-term implications. Below is a table that demonstrates this.



Of course there are other nuances and filters that could be applied that could increase or decrease this edge. But generally there has been a poor track record following inside days. It's been fairly steady, too. This can be seen in the equity curve below which uses a 2-day holding period.

Why Inside Days Get Me Down

Friday was an inside day. For me that meant laying in bed most of the day trying not to vomit. For the market that meant a lower high and a higher low than Thursday causing Friday’s range to be completely “inside” Thursday's range. The indices also closed lower on the day. Below is a chart of the SPY going back to October 8th, which was the day it closed at its highest level. Every inside day with a down close is marked with a blue dot.



The return following each of the inside days with a down close is as follows: -0.48%, -2.62%, -1.27%, -2.45%, -2.64%. That is an average loss of 1.9% the following day. Five for five losers. The pattern isn’t pretty.

Even before the recent market top, this pattern has had bearish tendencies. Looking back to the beginning of 2004, there have been 53 inside days with down closes for the SPY. Sixty-four percent of them were followed by a selloff the following day. The average loss was about 0.7% and the average gain 0.5%. Total losses outsized total gains by 2.3 to 1.

Looking back even further, since the 2000 market top, the SPY has closed down 58% of the time following an inside day with a down close. There were 104 occurrences. The average loss the next day was 0.9% while the average gain was 0.6%. In all total losses outsized total gains by about 2.1 to 1.

Friday’s pattern may have been an ideal one for me while trying to deal with the flu. For the market, the pattern has historically signaled short-term trouble.

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Two other quick notes:

After conducting the study I did a search on “stock market inside day”. Dr. Steenbarger had an interesting study regarding them a couple of years ago.

In the comments section after my study of leadership breadth at market bottoms on Thursday night there was some discussion of the importance of looking at new low figures near market bottoms. Dr. Steenbarger also saved me some time this weekend and wrote a nice post on new lows near market bottoms. Thank you Dr.! (Now how about a little something for the nausea?)

Why Inside Days No Longer Get Me Down

SPY failed to make either a higher high or a lower low than the day before. This is often referred to as an “inside day” because the range was completely inside the previous day’s range. In the past I have shown how inside days under the 200ma have often been followed by moves lower. What’s interesting is that while that held true for a long time, since the bottom in 2009 it has not been the case. Let’s first look at an updated results table based on this setup.



As you can see the statistics still appear bearish, with the downside edge basically playing out over the 1^st 3 days.  But now let’s take a look at the profit curve.





As you can see over the last two years (and 15 or so instances) the setup has not provided a downside edge.  Both the 1-day and 2-day profit curves looked very similar to this. 

It is important to understand when historical instances provide a directional edge.  But the market is always evolving.  And sometimes setups that provided an edge for a long time will either stop working or will go a period of time without demonstrating the same tendency.  It is important to monitor not only how has a setup performed over the long term, but also keep an eye on recent instances to ensure that edge is still being provided.  In this case it doesn’t seem to be.

Some Potentially Bearish Inside (Day) Information

I’ve shown before that inside days in long-term downtrends are often short-term bearish. (An inside day is a day like Friday where the market makes a higher low and a lower high than the day before.) So what if that inside day closes higher and comes immediately after a 20-day low like we are seeing now?

Instances are a little low but initial results here appear quite bearish. As I note below the chart I also included a column showing the max losing trade. While it is very large, it was not just one outlier, but 3 extra large decliners that cause the average trade to look so weak. Note though that even 2 days out, prior to the extra large declines taking place, the edge still appeared fairly bearish.

Of course the market appears ready to gap up big this morning. There is certainly the possibility that a large gap up could trigger a short-selling rally which would run overrun the inclinations of this study.

Quantifiable Edges Identified in Q1

With the 1st quarter behind us I thought a summary of what we learned on the blog through the studies would be interesting. (You should also note that most of these studies are now available in the 1st Quarter 2008 Quantifiable Edges Studies Package for Tradestation users.)

If the VXO spikes higher and the market doesn't rebound...look out below!

Some kinds of reversal bars really do work. And so do others.

IBD Follow Through Days provide an edge - but it's not as advertised. (FTD's are not included in the 1st Quarter Studies Package but will be separately available soon.)

When time gets stretched, price reversals are typically close at hand.

When capitulating markets bounce, it's the most beat up stocks that bounce the highest. (Not included in Q1 package -study done outside of Tradestation.)

When the Nasdaq and Russell get disjointed it typically means volatility and rising prices.

Large gaps in downtrends should be bought. Both down and up. (Not included in package - done mostly outside of Tradestation).

Big Arms can lead to next day buying.

Inside Days have a tendency to lead to short-term downside.

Some contracting ranges suggest more upside.

3 up days in a downtrend tend to lead to selling.

Failed gaps aren't as bad as they seem.

Triangle breakouts are highly unreliable and may provide an edge to fade.

A late surge may or may not carry over to the next day.

Not all breakouts are good.

Nasdaq Leadership can be important.

There is a recent edge on the 1st trading day of the month.

Four months lower doesn't mean we're going up.

More proof reversal bars work.

Put/call ratios can help signal a reversal is near.

Stretched VXO readings are generally a short-term positive for the market.

New low divergences are nice but not overly positive.

Strong moves off bottoms can lead to intermediate-term rallies.

Sharply declining consumer sentiment tends to precede stock market lows.

Fed rallies tend to be short-lived.

Overbought in a downtrend can lead to some nice shorts.

Light volume on a pullback isn't necessarily positive.

The market doesn't get marked up on the last day of the quarter.

And a few more.

In all, there are 45 studies included in the Quantifiable Edges 1st Quarter package. At a time when programmers charge $100 - $150/hr, I’m offering the entire package for $195. That’s about $4.33 per study. All open coded. Flexible inputs for further research. Ready-to-import data files for those studies that need it (like the Consumer Sentiment Index study). If you want to test you own ideas in Tradestation, this group of studies can also provide some nice templates to work with. Click here to purchase and you can download and import the studies and workspaces into Tradestation in just a few minutes.

I'll bet the 2nd quarter teaches us just as much as the 1st...

Why The Equity Curve Is Importnat In Evaluating Studies

While I don't always show it I do always look at the equity curve when evaluating studies to include in my analysis.  Last night while conducting my research I came across a great example of why this is important.

Inside days have generally suggested a bearish edge when the market is below the 200ma and no edge much better than upside drift when above the 200ma. I found it unusual that the inside day came with an unfilled gap down so I tested the possible effects under these circumstances.

At first glance the numbers seemed to suggest a downside edge. A closer look showed the numbers to be misleading. Here are the results in table format.

Base on this the next 1-3 days would seem to have a bearish inclination. But here is a picture of the equity curve.

As you can see it has been a long time since this setup has produced compelling odds.   Researchers should always take a look at the equity curve when considering whether to incorporate results into their analysis.

Another blogger who often makes this point is Michael Stokes of MarketSci.  He did it again in his recent Thanksgiving returns post yesterday.

Put/Call Drop

After spiking a little the week before last, the CBOE Put/Call Ratio dropped fairly sharply over Wed-Fri. Below is a study I ran last night showing the implications of similar drops:

Not the most bearish study I've ever seen, but it hints that the market may struggle to add to its gains over the next 2-4 days. I'm seeing some warning signs that the going could be tough here very near-term. Caution may be warranted.

Friday also posted an "inside day". If you'd like to review possibe implications of this, you may want to check out the old inside days studies.

Can Contracting Range Hint At Direction?

After the negative inside day on Friday, the S&P refused to sell off hard and even posted a decent gain today – breaking its recent streak. Perhaps this may signal a change in character from the downtrend since the October highs. Traders may not be looking to leave the party every time there’s a pause in the conversation.

Speaking of pauses, have you noticed how the price range has been tightening? The range over the last 3 days has been the tightest of any three days since December. Even more interesting to me is that over the last 13 days, the high-low range the S&P 500 has traveled has barely exceeded the range it traveled in the one day prior to that. The SPY on January 23rd had a range of $7.35. Since then the total range has been $7.88.

Looking at the S&P 500 cash index I went back to see other times the market traded in a range nearly as tight relative to one bar over a 13-day span. The parameter I used was that the range of the last 13 days had to be within 115% of the range of the 14th day back. I found 31 other occurrences going back 30 years. Twenty-five of those occurrences saw the market higher a month later. Only three times that I found was the range contraction followed by a break to the downside which led to significantly more selling. Those occurrences were August 1985, September 1990 and August 1998.

This study seems to be another example of what I’ve been seeing lately. Over the next several weeks risk/reward appears to favor the upside. Even this contracted range has some serious volatility, though, so risk should not be underestimated. Good timing and proper (reduced) position sizing appear key.

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On another note, I was pleased to have my recent post on leadership breadth appear in this week’s Festival of Stocks along with many interesting columns from other bloggers.

Does An Inside Day After An Outside Day Provide a Directional Edge?

After posting an outside day on Friday, the SPY followed up with an inside day on Monday. This was also noted by Scott Andrews of Masterthegap.com last night. I’ve recently become acquainted with Scott’s work and find his application of statistical analysis to trade gap fills very interesting. I ran some tests to see if the outside day / inside day combination provided any edge over the next few days.

The initial results looked like there was a possibility of a mild upside edge. Further investigation suggested the edge more likely is non-existent. Below is a profit curve that shows a 4-day exit strategy which should explain why I say this.

From this chart is appears that an edge MAY have been in place during the raging bull of the 1990’s. At that time just about any consolidation was followed by a strong move up. Since the end of 1999, though, the profit curve is a complete flatline. It appears that whatever edge there may have been back then is no longer in effect.

The 3-Day Pattern That Suggests A Bearish Edge For Today

The last 3 days have created an interesting setup.  Thursday SPY made a new 50-day closing high.  Friday SPY posted an inside day.  And then Monday was another 50-day closing high.  This has only happened 16 other times since 1999.  Below is a list of all the instances along with their performance the next day.

Risk/reward here heavily favors the short side. The average drawdown is nearly 4 times the size the average run-up. Also notable is that every instance saw drawdown of at least 0.35% the next day, but only 1 of the 16 instances saw run-up of at least 0.35%.  Futures are up 2.5 points right now about an hour before the open, but there may be some headwinds based on this pattern.

An Unfilled Up Gap / Inside Day Pattern

Today’s movement will largely be due to the market’s reaction to the Fed.  But I thought I would share a study that triggered yesterday that would perhaps have a bit more influence on a non-news day.  It looks at days like Tuesday where the market gaps higher, never fills, and moves higher from open to close without making a higher high.

Implications here appear somewhat bearish, with most of the damage occurring on day 1.  Traders may want to keep this pattern in mind for the future.