How Markets Really Work – Free

I’ve had the pleasure of doing some work with and for Larry Connors. His ideas have inspired a good amount of the work I’ve done over the last several years. I’ve mentioned before his book “How Markets Really Work”, which has many interesting facts and observations in it. When I went to the TradingMarkets site today I noticed they were allowing free downloads of the book until Monday night. I’d highly recommend people download and read it. Here’s the link:

How Markets Really Work

Consolidating Gains

Today’s action didn’t appear spectacular in any way. The market consolidated its gains on ho-hum volume. While my blog yesterday indicated Tuesday’s big gains served as further confirmation that the market was likely to continue higher for at least a few weeks, the short-term is not as bullish. Most of the time there is some brief give back after such large moves.

I ran some numbers tonight looking at action immediately following up days of 3.5% or more in the S&P 500. Of the 35 instances since 1960 that my scan found, 31 of them traded lower than their thrust day close at some point in the next 5 days. (Make that 32 for 36 after Wednesday.) 18 of the 35 traded lower by 1.75% or more.

What’s this tell me? The pullback today was normal. In fact, continued pullback would be normal. The last two big thrust days (3/11 and 3/18) the market fell hard and fast almost immediately. If the market can get through tomorrow without a sharp selloff, that could be a positive. It would be a change in character.

Some Historical Comparisons

On Tuesday the SPY gapped up over 1.25%. Hopefully readers of the blog recalled that this was not a signal to either go short or take profits on longs. Large gaps up during downtrending markets have a tendency to trap shorts and lead to further intraday gains. This was the case today as the S&P 500 and Nasdaq Composite both finished up over 3.5%.

On March 19th I ran a study that looked at market performance following two 3.5% up days in the S&P 500 within 10 trading days. Results following this type of occurrence were quite bullish over the next 2-6 weeks. There were also some major bottoms identified. Below is a copy of the results table I displayed that day (therefore it doesn’t include the March 19th, 2008 occurrence). $100,000 per trade.

Today we once again saw the 2nd day in the last two weeks to make a 3.5% gain. In fact, that now makes 3 times in 15 trading days. That has only happened two other times since 1960: October of 1987 and October of 2002. Those dates may sound familiar. I posted graphs of those two periods in my March 20th column. They were the only two times other than March 19th and 20th that saw the market rise 4% one day and then drop 2.4% the next (since 1960).

The market continues to provide incredible volatility. In the past this volatility has been associated with intermediate or long-term bottoms. There was probably a fair amount of short covering today. There was also probably a fair amount of short covering in October 1987 and October 2002.

On its own it would be very dangerous to read too much into a study with just two prior occurrences. Taken together with all of the previous intermediate-term studies I’ve referenced over the last few weeks, today’s action acts as confirmation that the market should put in generally higher prices over at least the next several weeks.

If you use Tradestation and would like to purchase and download tonight’s study, you may do so here. (It’s also included in the March 19th package.)

Stuck In The Middle & An Announcement About Studies

I ran several different studies tonight all of which told me basically the same thing…nothing. From a short-term perspective I am not seeing much in the way of an edge. Let me quickly illustrate why. Below is a 60-minute chart going back to January.

Seems like a lot of movement to go nowhere. The market is right smack dab in the middle again. Rather than try and pick sides here, I’d prefer to wait for a clearer edge.

One notable about tomorrow is that it is the 1st day of the month. Since 1995 the first day of the month has been profitable about 2/3 of the time. (Before that there was no discernable edge.) More details on “1st day of month” can be found here.

I have several new things in the works right now, including a volume study that I hope to complete and release in the next week or so. As some of you may have noticed, I am now making the studies available for Tradestation users to purchase and download. By sometime this weekend I hope to have nearly all studies for Q1 available. I will be offering packages of the studies so that people may either examine the ideas further or use them as templates in conducting their own research.

What Are The Chances The Market Gets "Marked Up?"

As we near the end of the quarter I’ve begun to hear quite a bit about the “end-of-quarter markup” phenomenon. I’ve also received a few questions about it. The theory is that mutual funds and other large institutions tend to “mark up” the prices of securities at the end of each quarter so that their return numbers look better. I decided to take a look.

First I ran a test which showed the return of the S&P 500 on the last day of each quarter going back to 1960. Of the 186 quarter-ends over the period, 90 have had a positive last day of quarter, 94 finished negative, and 2 were basically dead even. The average win was 0.065%. The average loss was 0.06%. The net average day was 0.001%. Not even as good as an average day over the period.

I then checked to see what happened if the market sold off the few days leading up to the last day of the quarter (like now). For instance, 7 times the market sold off at least 2.5% in the last 3 days of the month. Five saw gains on the last day and two saw more losses. Unfortunately, the losses nearly eclipsed the gains. Lowering the requirement to a 1.5% selloff in the preceding 3 days gave 18 trades. 9 winners and 9 losers. Net expectancy was slightly negative.

I then looked at what happened if the S&P was down at least 3 days in a row just before the last day of the quarter. Twenty occurrences. 10 winners. 10 losers. Slight negative expectancy.

Looking at recent history rather than all the way back to 1960 did not help these studies.

No matter how I looked I was not able to find any evidence of an end of quarter mark-up in the index. Perhaps mark-ups occur in individual securities, but it’s not apparent in the general market.

Since I figured some people might be getting sick of looking at those “Myth Buster” guys, I posted some other Busters today…

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Would you like to explore these studies more? Or customize them with your own ideas? Quantifiable Edges studies are now available for purchase in Tradestation format along with pre-set workspaces. Click here for more details and a complete list of available studies. Click the buy now button below to download and install directly to Tradestation.

EOQ Markup – $12.00

Review Of Recent Studies

The market has now sold off for two straight days. Of some concern is that I’m not seeing evidence that anything is overdone to the downside. For example, I looked at all stocks in the S&P 100 tonight along with my list of 115 highly liquid ETF’s that I track. None of them made a 10-day low on Thursday. None. Breadth is not suggesting we are due for a bounce.

Price-wise we are back to the middle of the recent range. I have very little to add tonight so I thought I’d do a quick review of outstanding studies. Earlier this week there were several bearish studies which had short-term influence. That influence is beginning to dissipate. Those studies may be found here and here.

Prior to these I had posted several bullish studies with intermediate to long-term influence. Each night in the Subscriber Letter I list all outstanding studies, their time frame and their bias. I find it a useful graphic for helping me organize my thoughts and determine my own trading bias. The bullish intermediate-term studies I consider active are listed below along with the time-frame they looked at.

March 24, 2008 Nasdaq Leadership Bullish - 1-10 weeks
March 19, 2008 Bottom Explosion 2 – 1-20 days
March 19, 2008 3.5% Up Cluster - 10-20 days
March 17, 2008 Consumer Sentiment Stretch – 1-12 months
March 12, 2008 Bottom Explosion – Now What? – 1-20 days

In reviewing them you may notice that many are just beginning to reach their sweet spot.

While the pullback may or may not have farther to fall I am not seeing evidence at this point that it will be anything more than a pullback.

Light Volume Pullback (A Good Thing?)

The standard line on days like Wednesday goes something like this:

The S&P 500 pulled back today on light volume. After the recent run-up the market was due to pull back. The light volume is a sign that selling was not aggressive and should be viewed as a positive. The pullback appears orderly. It would seem buyers just stepped away. There doesn’t appear to be any heavy institutional distribution.

Does any of the above sound familiar? It seems to make sense. Everyone claims they want the market to pull back on light volume. It’s in plenty of books so it must be true. Hmm…

I ran some tests on the S&P 500 looking for the following conditions:

1) Yesterday the 3-period RSI was above 70 (showing there has been a short-term run-up).
2) Today the market closed lower than yesterday.

Buy at the close. Sell “X” days later. Over the last 25 years here is what the S&P 500 has done 3,4, and 5 days out after this setup:

Over the next 3-5 days the market has managed very slight gains.

Next I added a 3rd condition to the mix:

3) Volume must be the lowest volume of the last 10 days.

Again I’m buying at the close and selling “X” days later. Over the last 25 years here is what the S&P 500 has done 3,4, and 5 days out after this setup:

Apparently the “buyers stepped away” on day 1. Over the next few days the sellers filled the void. Very light volume at the beginning of a pullback does NOT appear to be a good thing.

Another myth busted.

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.

Updated CBI Chart

The Capitulative Breadth Indicator (CBI) returned to “zero” yesterday, finally closing out the last of the recent trade cluster. Below is an updated chart of the index. The “buy” and “sell” arrows on the chart once again show the results if one was to buy the S&P any time the CBI hit 10 and then sell it when it closed at 3 or below. I’ve discussed this crude market timing system in the past. Since 1995 it would now have proved profitable in 18 out of 18 trades – most of which occurred during “scary” selloffs.

For those interested in tracking the trades behind the CBI real time, they are provided to subscribers in the Quantifiable Edges Subscriber Letter. Also in the Letter is CBI percentages of 24 different market sectors.

Market Getting Overdone Short-Term

I looked at a lot of studies in the past week or so and they’ve all said pretty much the same thing: the edge was to the long side. Over the last two trading days the market has shot up impressively. I am now seeing some short-term indications that it is due for a pullback or at least a rest. Let’s look at two quick examples – one price based and one sentiment based.

Price
I looked at shorting the S&P 500 under the following conditions:
1) The S&P closed below its 200-day moving average
2) The S&P rose at least 1.5% the last two days in a row.

Results below ($100,000 per trade):

Based on the price action it appears a pullback is likely to begin soon. A modest edge is apparent to the downside after day 2.

Sentiment
I then looked at the position of the VXO – as a gauge of sentiment rather than price. I looked at the performance of the S&P 500 under the following conditions:
1) The S&P closed below its 200-day moving average
2) The VXO closed at least 10% below its 10-day moving average.

Shorting the market under these conditions and covering when the VXO closed back above its 10-day moving average would have produced the following results since 1987. 51 total trades. 31 (61%) winners. Average winning trade = 2.2%. Average losing trade = 2.6%. Expected value = 0.3% per trade. Profit factor = 1.3.

Not an overwhelming downside edge here, but more evidence that continued upside may not be in the making.

Based on price and sentiment measures, a pullback beginning in the next few days seems to be a likely scenario.

Nasdaq Taking Leadership Helps Bullish Case

A few weeks ago I posted a study which discussed the implications of the lagging relative strength of the Nasdaq versus the NYSE. The results of that study were strongly negative from 1-10 weeks out. Last week I noticed the Nasdaq was trying to take the lead back from the NYSE. When the market closed for the week the Nasdaq did manage to barely overtake the NYSE based on the indicator I’ve described in the past. A very astute subscriber to the Quantifiable Edges Subscriber Letter also noticed this and sent me a note asking me to comment on the significance in light of my study of a few weeks ago. I’ve updated the chart from a few weeks ago below. The red line has now barely crossed the yellow line signifying the Nasdaq’s RS is slightly stronger.

I ran a few studies to determine the possible significance of the Nasdaq taking the lead. The first one simply looked to buy any time the Nasdaq went from “lagging” to “leading”. On the chart above this would be shown by the red line crossing above the yellow line. The results are below.

Overall the results were generally positive going forward. I then looked at situations like the present where the Nasdaq rebounded from an extreme lagging position as described in the previous study and then crossed over to take the lead. There were 15 such occurrences. The performance of the NYSE from 1-10 weeks out can be found in the table below.

It appears this situation is more even more favorable than a typical cross.

I then adjusted the exit criteria to change this study into more of a system. Rather than exiting “X” weeks later, I said to exit whenever the red line re-crossed below the yellow, which would represent the Nasdaq falling back to a lagging position.

Buying when the RS upward cross occurred and selling when the Nasdaq’s RS line crossed back below the NYSE would have produced 11 winning trades and 4 losers. The average winning trade was good for more than 5% and the average loser saw a decline of less than 1.2%. The length of the average winner was 7 weeks vs. 5 weeks for a loser. If $100,000 was allocated to each trade (assuming no commissions or slippage) the gross profits on winning trades would have been $50,901.45 versus gross losses of $4,617.18 for the losing trades. This equates to an outstanding profit factor (gross gains / gross losses) of 12.02.

It appears the change in the Nasdaq from “lagging” to “leading” status is another argument for the bullish case.

A Few New Links

I’m taking some time off from writing this weekend. I’ll be back tomrrow night with some thoughts. In the meantime, I’ve added 3 new links to my relatively small blogroll.

1)bzbtrader - Much of the focus on this blog has to do with short-term QQQQ trading. His “Weekly Updates” provide a nice overview of the market with some interesting indicators.
2) Chart Swing Trader - Market analysis with an IBD tilt. What I most enjoy about Chart Swing Trader is that he posts many charts and individual stock ideas. Few bloggers seem as willing to share their watchlists as extensively as Chart Swing Trader.
3) IBDIndex - A blog not even a month old, the IBD Index takes a quantitative look at the IBD 100 Index. Complete with backtesting of IBD style trading ideas this blog has a few gems already. I’m looking forward to seeing results of the “Future Testing Ideas” listed on this site as well.

Big Drop After A Big Up Day – A Rarity That Has Occured Near Bottoms

Last night I went through a host of studies that all led to bullish conclusions for the intermediate-term (10-30 days or so). Today the S&P 500 dropped 2.4% and the Nasdaq 2.6%.

The Explosive Moves off Bottoms study last night identified 10 instances where new lows were followed by 3.5% up days. The 5/27/70 instance continued higher without a short-term pullback. The 7/5/02 instance dropped lower and didn’t bounce for a long time. The other 8 instances all experienced a pullback within a few days before heading higher. The average pullback of those 8 instances was 2.6%. So the size of the pullback today isn’t alarming. I just wasn’t expecting it to happen all in one day.

I ran a test to see other times where the S&P 500 has risen 4% or more one day and then dropped 2.4% or more the day after. Being near a market low was not a requirement. Since 1960 it has only happened twice.

The first was October of 1987. (See red dot.)

The second time was October of 2002. (See red dot)

It’s difficult to extrapolate much from just two instances, but I found it interesting none the less that the only other times this has occurred was near major market bottoms. One caveat is that today’s decline came on higher volume while in 1987 and 2002 it came on lower volume. Hopefully today will keep enough people on the bearish side that the rally can take hold. Investors Intelligence saw a slight drop in bulls to 30.9% and a slight rise in bears to 44.7% making that index even more extreme. Put/call ratios remain high and the VIX headed back up close to 30. My intermediate-term bullish bias has not changed.

History Says To Expect More Upside In The Coming Weeks

Last week I looked at explosive moves off bottoms. Today’s was quite similar. I ran a test similar to last week to see how the market has acted under the following circumstances: 1) The S&P 500 made a 100-day low yesterday. (Last week I looked at closing lows. This week it was intraday lows.) 2) Today the S&P rose at least 3.5%.

I found 10 instances that met these criteria. 6 match last weeks test. Those are listed below along with my notes from last week.

5/27/70 – Shot higher for another 5 days in a row before resting.
7/12/74 – One more up day before 1 ½ day pullback followed by 1 week drift higher.
10/20/87 – One day higher then 3 day pullback before bouncing back up.
9/1/98 – 3 down days then next leg up.
9/24/01 – 1 more up day followed by 1 ½ day pullback then move higher.
5/8/02 – 2 day pullback of 3% followed by a 1-week rally that ultimately failed.

The four new ones are:

10/28/97 – 2 day pullback before next leg up
7/5/02 – A disaster of a an entry.
7/24/02 – Small 1-day pullback, then rocketed higher.
10/11/02 – 2 more days up before a small one day pullback and then further move higher.

The theme remains the same as last week. They have usually been followed by a pullback within the next 3 days and then a move higher.

I then decided to look at performance following any day the S&P 500 rose at least 4%. Results below: ($100,000 per trade)

Looking out 2 weeks there appears to be a huge bullish edge. Thirteen of fifteen winners and an expected value of 3.6% over the period. Going out 90 days the average trade would have returned over 9%.

Looking at the table you’ll notice that the number of trades is reduced the further you look out. This is due to clustering of some trades. Clusters of days with strong percentage gains have been bullish in the past. I looked at all the times when the S&P had two days where it gained 3.5% in a two-week period. Seven instances were found. They were: 10/9/74, 8/20/82, 10/21/87, 9/8/98, 4/18/01, 7/29/02, and 10/11/02. Some important turning points among that list. Below is a table summarizing the returns: ($100,000 per trade)

The strongest edge appears in the month following the cluster.

Also of note is the fact that breadth was extremely positive today. Upside volume swamped downside by more than 9:1. Last week we just missed a 90% upside day, posting 89%. While it doesn’t quite fit the criteria, I did a study in November on my old blog looking at 2 90% upside volume days within a 5-day period. Results were extremely bullish, although that instance did not work out well.

In all, I’d have to say that today’s action was very bullish. Combining it with last weeks and taking into consideration such things as put/call ratios, VIX levels, etc and I’d say there is a good chance the next month or so will lead to higher prices. Will it turn into a strong bear-market rally that eventually rolls over? Don’t know. Don’t really care. What I see in front of me is quite bullish over the next several weeks. Buying pullbacks could work very well. As I discussed above, we’ll probably see lower prices at some point in the next week. Last night’s Fed study also suggested a pullback in the coming days is likely. Therefore, chasing this is likely not necessary. I’ll be ready to add to my positions if it does pull back.

Sharp Rises On The Morning Of A Fed Meeting

The large gap up this morning is quite unusual on the day of a Fed meeting. I ran a test back to 1983 to find other times the market was significantly higher at 1:30pm Eastern time on the day of a Fed meeting. I was only able to find 3 other times where the market was up at least 1.5% by 1:30. On 8/21/84 the market tacked on another 0.04% in the afternoon. On 12/18/84 it added another 1.37%, and on 1/5/88 it lost 0.64%.

It will be interesting to see how today plays out.