Below is a study from Friday night’s Quantifinder that was originally published in the Weekly Research Letter. (click to enlarge)

Instances are a bit low, but 17 of 19 occurences had at least one close below the trigger day close within the next 4 days. This study seems to suggest decent chance of some downside over the next few days.

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One blog I enjoy reading is Cobra’s Market View. He shows a lot of charts and often does a good job finding where there is unusual action. On Thursday night he noted the CBOE Equity Put/Call Ratio had come in extremely low. I decided to do a study on performance following extremely low 1-day readings.

When looking at put/call ratios I always normalize them with a long-term moving average. To understand why you may review this post from June of 2008. For today’s study I normalized using the 200-day moving average. The Equity P/C Ratio today came in at 0.55, which is a little over 25% below the 200ma of 0.74. I then looked at all other times the Equity P/C came in more than 25% below its 200ma.

(click to enlarge – created with Tradestation)

As you can see in the above table, while there seem to be negative implications from such readings, they only last 1 day. Now let’s take a deeper look at those 48 trades and see what the results looked like over time. (Chart from Tradestation.) Click to enlarge.)

From 2004 until near the end of 2007 there wasn’t much of an edge provided. From November 2007 – present though there has been a strong bearish tendency. Seeing this graph would make many people wonder whether the negative performance is primarily just a byproduct of a horrible bear market.

There’s no way to answer this for sure. One thing we can do though is to see what performance has looked like since the March bottom. All qualifying trades are listed below:

(created with Tradesttion.)

Even during the furious rally of the last 3 months low readings in the Equity P/C Ratio have been followed by strongly negative action. This leads me to conclude that the CBOE Equity P/C Ratio may provide a short-term edge and its suggesting downside for Friday’s trading. I’d recommend checking out Cobra’s Market View for several interesting charts and observations on a daily basis.

P.S. – Would you like to be notified every time the above setup occurred? The Quantifinder can do it. Let the Quantifinder search through my blog and Subscriber Letters and alert you to studies relevant to current market action. Available with all Gold and Silver subscriptions.

A few weeks ago I wrote a post that illustrated the edge buying 3 down closes has produced over time. There are a lot of ways to expand on the research in that post. Today I’m going to look briefly at what its meant to be down “X” number of days in terms of an edge for the next trading day.

The table below looks at performance the day following a drop in the SPX of exactly X days in a row.

A few things caught my eye here. The first is the % Wins column. It stayed pretty close to 50% no matter how many down days you’ve had. Basically a coin flip either way. The 2nd column that caught my eye was the Avg Win column. This is the column that provides an edge when you get further out. In general the more stretched market the stronger the bounce is likely to be.

As I showed in the post that focused on 3 days down, the edge has changed over the years. More recently there has been a greater tendency for the market to reverse rather than trend. Below is the same table for the 1989 – present time frame.

The % wins column here shows that the tendency to reverse after being down several days has grown stronger in the last 20 years. As in the 1st table, the Avg Win increases as the SPX gets more stretched.

I demonstrated with the “Down 3 Day” trade that much of the edge has come quite recently. Below is an equity curve for being down 5 days.

Much the same here. A good majority of the edge is attributable to the last several years.

My takeaway is this. There is a long-side edge after the market has pulled back for several days in a row. A large part of the edge comes not from the chances the market will rise the next day, but the fact that you will be rewarded amply if it does. If you understand this and perhaps combine the fact that the market is down multiple days with other indications that a reversal is likely, then you can likely identify a strong upside edge.

I noted in Thursday night’s Subscriber Letter that AAPL and GOOG had both risen for 8 days in a row. Additionally, those two along with MSFT and ORCL all had 2-day RSI’s of over 98. That’s an extremely overbought level. These 4 stocks are among the top 7 and make up about 26% of the Nasdaq 100. Using the list of current Nasdaq 100 stocks I studied action among the current 8 highest weighted. In addition to the 4 above this includes RIMM, QCOM, CSCO and GILD. I looked at other times since 2007 that at least 4 of these 8 stocks closed with a 2-day RSI in excess of 94. Those results are below:

It’s not exactly a layup that a pullback should immediately begin. Still, risk appears to greatly outweigh reward when several of the top components are strongly overbought short-term. A brief look at the W/L Ratio suggests this. A pullback does normally come at some point in the next few days though. In fact of the 21 instances where the conditions were met, only one did not experience a close below the trigger day’s close within the next 4 days.

Last August I looked at clusters of large low-volume selloffs. While the S&P hasn’t quite met the parameters laid out in that blog post, it has met the loosened requirements which were looked at in the 8/1/08 Subscriber Letter. The Quantifinder picked up on this last night and I thought it was worth another look. The basic concept is as follows. Strong moves down often lead to bounces. When you have a series of them occur on low volume then you may have favorable risk/reward on the long side.

There appeared to be an upside edge when I ran this test last summer and there still appears to be one.

Last week I discussed an indicator designed by Gerald Appel and published in his book “Technical Analysis – Power Tools for Active Investors”. He refers to it as the Nasdaq/NYSE Relative Strength Indicator (not to be confused with RSI). I changed it slightly for my purposes and instead of tracking the Nasdaq vs. the NYSE, I instead tracked the Nasdaq vs. the S&P 500. In last week’s post I demonstrated that the S&P had performed much better over time when the Nasdaq was in a leading position.

I also provided a spreadsheet with the calculation and a model based on the indicator on the free downloads section of the website.

When conducting research or designing models it’s important to avoid just looking at it from one angle. Today I’m going to explore a couple of other ideas that the indicator / model may have invoked in many of you. I’ve also updated the spreadsheet so that you can see how these ideas were tested as well.

First, a quick refresher chart of last week’s results.

As you can see, utilizing the indicator would have greatly enhanced your returns over time. So if owning the S&P when the Nasdaq is leading is so favorable, does that mean you should short the S&P when the Nasdaq is lagging?

Below is an equity curve of a $100,000 investment doing exactly that. (Interest and dividends are not included.)

After almost 40 years the current (recent?) bear market just got you back into the black. Certainly this isn’t an equity curve that suggests an edge. While some may be surprised based on how positive the previous results were, it makes complete sense. The strategy in this chart calls for shorting the leading index. I don’t believe I’ve ever seen anyone who has suggested that to be a good idea.

But what if instead of buying the S&P when the Nasdaq leads, we buy the Nasdaq? It is the leader after all.

Equity chart below. Hold on to your hats.

Like the original test, dividends are not included. The annual growth rate if you earn 2.5% interest on your cash balance is about 13%. This is more than twice the S&P 500 annual growth rate of under 6% for the period. There’s also lower drawdown and you’d only be in the market a little more than half the time.

Last week we saw how timing the market with this simple indicator can make a big difference. Here you see that a small tweak to ensure you’re in the leading index can juice returns much, much more. There are numerous other tweaks you could add to the model to improve performance or reduce drawdowns further. This is as far as I’m going to take it, though. The spreadsheet is still available and updated with the above tests and charts. You may download the updated version on the free downloads page. I’d suggest anyone who downloads it should use it as a starting point – not a finished product.

For more ideas on using Excel for historical analysis I’d recommend buying Dr. Steenbarger’s Daily Trading Coach book. A few weeks ago I created a sample spreadsheet based on the lessons in that book. You may download that spreadsheet on the free download page as well. Registration is required for the Nasdaq/S&P Lead/Lag Model. Registration is NOT required for the Daily Trading Coach Spreadsheet.

I’ve discussed a few times in the past that when the SOX rises in the face of a selloff it is often a good thing. In the 8/13/08 blog I looked at performance following times wherer the SPX dropped 1% and the SOX rose on the day. Below is a slight twist on that study that looks at returns following an SPX drop of 1% with an SOX rise of 1%.

(click table to enlarge)

Three to four weeks out you’re looking at 90% winners. The average S&P gain over the next 4 weeks was over 4%. Even the instances over the last year were followed by positive numbers over the next 3 weeks or so. They were 7/15/08 (+5.75% over the next 15 trading days), 8/7/08 (+2.73%), 12/9/08 (+1.64%), and 2/25/09 (+3.85%). Meanwhile, if you bought the leading SOX instead of the SPX the average 4-week trade across the entire sample set rose from 4% to 8.2%.

Score one for the bulls. (Although I’m still seeing several bearish studies as well.)

The market moved from the low end of its recent range to the high end on Tuesday. It’s quite rare for the S&P to close at a 5-day low one day and a 10-day high the next. Below is a table summarizing all such instances since 1960:

A negative bias seems to follow such occurrences over the 1-5 days.

Today I am going to discuss a slight twist on an intermediate-term indicator that I’ve discussed before. The idea comes from Gerald Appel’s book “Technical Analysis – Power Tools For Active Investors”. In it he discusses a relative strength measure of the NYSE vs. the Nasdaq looked at on a weekly chart. The premise behind the indicator is that the market tends to perform better when the appetite for Nasdaq stocks is greater than the appetite for NYSE stocks.Part of this is due to the higher volatility of the Nasdaq, and part of it is due to investors willingness to speculate more aggressively when their outlook is positive. Critics of the indicator suggest the reason it works is largely due to the higher beta of the Nasdaq. That may be part of it, but it doesn’t mean the indicator is without value. In fact, whatever the reasons behind it, the indicator has been an excellent barometer over the years. In the book, Mr. Appel suggests using a 10-week relative strength indicator to measure this phenomenon.

Since I normally trade the S&P 500 and not the NYSE Composite, I applied the indicator to the S&P 500. Doing so, I found the results to be even better. The indicator is shown in the chart below.

The two lines on the bottom panel are the relative strength indicator. When the solid line closes above the dotted line that means the Nasdaq is leading the S&P. When it closes below the dotted line, that means it is lagging the S&P. To make it even easier to view I’ve made the line green when the Nasdaq is leading and red when the Nasdaq is lagging. As you can see, the Nasdaq is currently lagging.

The performance can be evaluated a number of ways. This first equity graph (courtesy of Tradestation) shows the points gained in the S&P 500 since June 30, 1972 – May 15, 2009.

As you can see, over the time period measured the S&P gained 1,341.27 points when the Nasdaq was leading. Meanwhile, the total points gained by the S&P over the period was 775.74. The Nasdaq held a leadership position just slightly more than ½ the time during the period. So almost twice the gains (points-wise) were achieved in nearly half the time. Not bad.

What if you started with a $100,000 portfolio and compared buy and hold to only holding when the Nasdaq led?

I decided to show these results in Excel.

These results represent returns from 4/19/1971 – 5/22/2009. They do not include dividends. The pink line is the growth of $100k in the S&P 500. The blue line shows the results of investing in the S&P only when the Nasdaq is in a leadership position and earning 0% interest otherwise. The yellow line shows results if instead of earning 0% interest, you managed to earn a steady 2.5% interest on your cash balance while not in the market. While 2.5% isn’t easily doable today, over most of the time period it was extremely low.

It appears the only period where the Nasdaq/S&P Relative Strength Indicator didn’t provide an edge was during the 1995-2000 boom market when you would have wanted to be invested basically the whole time.

The ending value differences are striking. By sitting out of the market when the Nasdaq is lagging and earning a minimal interest rate on your cash, returns more than tripled. Nearly $2,000,000 more would have been earned on an investment of $100,000.

The Nasdaq/S&P relative strength indicator is well worth keeping and eye on and is a useful tool for measuring the health of the market.

The S&P 500 closed lower for the 3rd day in a row yesterday. Three lower closes is often cited as having an upside edge. And it does – kind of. That edge is often misunderstood, though. The first place I saw 3 lower closes quantified was in Larry Connors book “How Markets Really Work”. One of the chapters in the book looked at consecutive days higher and lower. It basically found that after the market has moved in 1 direction for several days, there is a tendency for it to revert.

He measured 3 lower closes in that book from 1989 – 2003. (All tests were run over that period. It wasn’t specific to this particular setup.) When Larry measured 3 lower closes he looked at any time the market had pulled back for at least 3 days in a row and then showed performance statistics for the following days. What many traders fail to realize when they review his research is that there is a large historical difference between “at least” 3 days in a row and “exactly 3” days in a row. I decided to examine this in some detail tonight.

First let’s look at a chart of buying the S&P 500 any time is has closed lower for at LEAST 3 days in a row and then selling the next day. Keep in mind, if it is down again day 4 it will be bought again. Same with day 5, 6, 7 etc. until there is finally an up day.

There are a few things to note here. First, trying to buy all 3+ day pullbacks prior to 1987 was a losing strategy. After that it the market showed less tendency to trend and an increased tendency reverse. Buying 3+ day drops became profitable. The period covered by the blue arrow shows the period covered in “How Markets Really Work”.

Now let’s look at what happened if you bought the market after 3 and only 3 lower closes. In other words, the third day lower was bought. The position was exited the next day. If the market continued to head south it was ignored. There was no further buying on day 4, 5, or 6.

There is a striking difference between the two graphs. There does appear to be a recent upside edge, but most of it is concentrated on some outlier trades that occurred in the last year. Until very recently there was no advantage to buying the third close lower in a row.

Why the stark differences? I believe much of the reason is due to the strength of the eventual snapback. The more stretched the market gets to the downside, the greater the snapback typically is. The “3 or more” study guarantees a winning trade in every sequence. In other words, it will continue to buy each day until it has a winning day. Only after that will the count reset. The further the market drops, the more vicious the snapback is likely to be.

Below is a table that illustrates this concept covering the time period of 1989 – present. The left hand column is the number of days the market moved lower. The right hand column is the average up day the following day. (Down/losing days are not looked at here.)

As I stated above, the longer the pullback, the stronger the snapback.

Also consider when snapback is most vicious…during bear markets. Note the two time periods on the 2nd equity chart where buying three lower closes has actually provided an edge on the 4th day. Those 2 time periods were during the current and prior bear markets.

So is there really an edge to buying (exactly) three lower closes? Recently during bear market periods – yes. Historically, no. Of course if you understand the mean reversion will likely eventually take place, you can still take advantage of the pullback. You will need some patience, though. Below is a chart of buying day 3 and holding for 3 days (rather than 1).