Friday, February 02, 2007

Four Consecutive Days of Strength: What Comes Next?

Each day on the Trading Psychology Weblog, I track the number of stocks making fresh 20-day highs and lows. This provides a general sense of whether market moves are gaining or losing participation from the broad list of stocks. Recently, we have had four consecutive days of rising new highs, culminating in 1966 new 20-day highs on Thursday. What has happened in the market after we've seen four such days of strength? Do we see a pullback, or does upside momentum carry forward?

Going back to 2004 (N = 772 days), I found 48 occasions in which 20-day new highs rose for four consecutive trading sessions. The next day, the S&P 500 Index (SPY) was up by an average of .21% (32 up, 16 down). That is considerably stronger than the average one-day gain for the entire sample of .03% (417 up, 355 down). It thus appears that, in the short run, strength begets strength.

I then examined a subset of the strong four-day periods in which new highs on the fourth day numbered 1500 or greater (N = 17). The next day in SPY averaged a gain of .09% (12 up, 5 down). Again, there tends to be some upside follow through after a surge in new highs.

When we look over a five-day horizon, however, a different picture emerges. Following four consecutive days of rising new highs (N = 48), SPY averages a subsequent five-day gain of only .11% (24 up, 24 down). That is certainly no better than the average five-day performance for the entire sample of .17% (440 up, 332 down). Indeed, when the four-day surge has resulted in more than 1500 new highs (N = 17), the next five days in SPY have averaged a loss of -.40% (4 up, 13 down).

What this suggests is that market surges tend to carry over into the next day of strength, but do not on average lead to outperformance over the subsequent week. Indeed, there seems to be a tendency for very strong markets to take a breather and digest their gains over the subsequent five days of trading. This pattern will provide some overall context for my day-to-day trading ideas.