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.

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.

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.

How The Market Might React To The Fed

With the market stuck in a downtrend many participants are saying “Help me Obi Ben Bernanke. You’re my only hope.” Bear Stearns managed to wipe away any chance of a pre-Fed meeting rally. Rallies leading up to Fed meetings are fairly common as investors hope for good news. Selloffs prior to meetings are not common.

Over the last two days the S&P 500 has dropped over 2.75%. I looked back to 1982 to find other times where the market has dropped at least 2.75% in the two days leading up to a Fed meeting. I found six other occurrences. They were 11/16/82, 7/8/86, 3/30/87, 8/19/91, 1/29/02 and 5/6/02. In 5 of 6 cases the market rallied on the day of the meeting. The Fed generally managed not to make things worse. The average gain the day of the Fed meeting was 1.0%. The lone loss was only 0.3%. Looking out 2 days all six were positive and the average gain was 2.3%.

So if we get the “average” 1% gain tomorrow, then what? Unfortunately, Fed-day rallies have a tendency to be short-lived. Again looking back to 1982 I looked at buying at the close of any day there was a Fed meeting and the market finished up 1% or more. As you can see by the table below, after two days there is a negative expected value. Going out two weeks it generally gets progressively worse.

The market is oversold on a price basis. The VIX is spiking. The Put/Call ratios continue to put up overly bearish readings, and the Fed is meeting tomorrow. All these things suggest a bounce. Unfortunately, the last two days look rather ordinary on a chart. There was no washout or accelerated move lower. This calls into doubt the possibility that today could serve as a bottom should the Fed along with the positives mentioned above spark a rally over the next day or two. Right now a reasonable roadmap to keep in mind might be a short, oversold bounce followed by another leg lower. I’ll continue to re-evaluate as the next few days unfold, though.

P.S. While some readers may prefer a shot of Princess Leia in the golden bikini to the picture posted above, gold closing over $1,000/oz today meant I simply couldn’t afford it.

Markets Fearful, Consumers Depressed

I had a lot of studies I was considering conducting tonight. Certain readings of fear hit new levels on Friday. The VIX closed at it highest closing level since March of 2003 on Friday. The spike up put it about 15% above its 10-day moving average. The CBOE equity put/call ratio hit an all-time high of 1.16. The CBOE Total Put/Call Ratio closed at 1.40. Extreme reading in all these numbers are not worth testing tonight. They are likely to all get more extreme tomorrow. With Bear Stearns being taken over for $2/share (down about 97% from Thursday) by JP Morgan the S&P Futures are down about 3% tonight and have traded below their January lows.

This should make for some interesting and exciting trading over the next few days. With this kind of gap down, my intraday trading will likely focus on the long side. On Monday or Tuesday I may be able to produce some studies that could have short-term significance, but tonight let’s look longer-term.

An extreme reading on Friday that went largely ignored due to Bear was the Michigan Consumer Sentiment Index. It came in at 70.5, which was the lowest reading in 16 years. Since this won’t change tomorrow morning I figured I would play around with that data a little.

Below is a chart. The top shows the S&P 500 and the bottom the Michigan Consumer Sentiment Index (blue). The red line is a ten period moving average of the index and the yellow lines are 10% bands of the 10-period moving average.

As you can see the drop in sentiment has been sharp and fairly steady over the last year. It has now closed below its lower 10% band for two months in a row. I ran a test to see how the market has performed when this has occurred in the past going back to 1/1/78 – which is as far as I have the Consumer Sentiment data. Results are below.

Looking out 9 and 12 months the only loser was the 2001 instance. In this case the sharp drop in consumer sentiment was still posting readings over 90. In the other 4 cases, all of which led to higher prices 9 and 12 months later, the index dropped below 75. This suggests things aren’t normally as bad as they seem. Hopefully that holds true this time. I especially hope it holds true for the employees and families directly affected by the Bear Stearns debacle.

Interestingly (and thankfully) the CBI did not budge Friday. It remains at 2. That could change dramatically in the next few days if a full-blown panic sets in.

Quick Friday Pre-Open Notes

Not much to say this morning. The CBI dropped to “2” yesterday, officially putting that indicator back into neural territory. I’ll post a graph of recent CBI activity in the next couple of days.

I continue to believe risk/reward favors the bullish case at this point. The extreme levels of fear and bearishness I’ve noted lately in such things as put/call ratios and Investors Intelligence survey lend support to the idea of a multi-week rally. My explosion off bottoms study remains in effect and also has a strong bullish tilt. Friday would be the first day that an Investors Business Daily Follow Through Day is eligible to occur so I’ll be sure to carefully monitor price and volume action in the indices.

Futures are looking to gap lower this morning. The CPI report will certainly have an effect on the tone of the opening. If futures worsen following the report then my intraday focus will once again be looking for long entries.

Informational Review

A few quick things to discuss tonight:

The Capitulative Breadth Indicator (CBI) closed at 4 on Wednesday. When looking at CBI-based index trades the standard exit I normally discuss involves the CBI returning to 3 or lower. On January 24th and January 29th I discussed a few alternate exit techniques which entailed taking the first profitable exit on a drop to either 8 or 5. The sharp drop to 4 today combined with the high likelihood of a pullback based on last night’s study leaves me temporarily index-neutral. Subscribers to the Quantifiable Edges Subscriber Letter received emails this morning advising them of the intraday exit triggers in CBI – eligible trades. By tracking these trades, subscribers can easily estimate the CBI ahead of time. The move to 4 indicates that the majority of the capitulative breadth has dissipated. The bounce was captured and it is now time to look at some other indicators to help determine the rally’s chances.

Last night’s study which looked at explosive moves off bottoms was especially compelling for me. Almost all of the results showed similar action – a quick pullback followed by another leg up. The only pullback that lasted longer than 3 days was the 1 instance where the market failed to rally further over the short-term – 11/1/78. If three days is the expected maximum and we’ve already had one of them, then I’m not looking to stay flat much longer. I’m focusing on finding favorable long entries.

Investors Intelligence numbers for this week came in at 31.1% bulls and 43.3% bears. (Chart from Market Harmonics here.) This is the first time bears have outnumbered bulls by that much since October 16th 2002. Extreme bearish readings have historically come at poor times to be short and have coincided with or preceded some significant turning points. The October 2002 date is also an interesting comparison to now for a few other reasons: 1) Although it just missed the 3.50% necessary to qualify for the study last night, 10/10/02 saw a rise of 3.497% off the bottom followed by a strong rally. 2) As there is now, there was a divergence of new lows on 10/11/2002 that was noted in the study posted a couple of days ago.

The world will be watching and waiting for a Follow Through Day now. I anticipate posting the last of my research on this subject in the next several days.

CBI of 15 Precedes Bottom Explosion – What Now?

The market gapped up huge this morning on the Fed liquidity announcement. Fading gaps and selling rallies have worked well recently for traders and in the morning that looked to be the plays once again. Readers of the blog know that large gaps up in downtrends have a sizable edge for further upside. The big money today for those who entered flat was not the gap fade, but rather finding a long entry to ride the afternoon market into the close. Buying into large gaps during downtrends provides traders a quantifiable edge. This is true for large gaps down as well as up.

With the Capitulative Breadth Indicator (CBI) up to 15 yesterday I was heavily long on individual trades and had taken on index exposure as well. I was looking for one of two things to happen before taking any more long index exposure: 1) A washout day to the downside. 2) An up close or reversal day.

We got the up close today to the tune of 3.71% in the S&P 500. That’s an exceptional one-day move. So the question now becomes, has the move come too far to chase at this point? It is better to wait for a lower entry point?

I ran some tests tonight to see how the market acted under similar circumstances. I looked at all instances where the S&P closed at a 100-day low and then exploded up 3.5% or more the next day. Looking back to 1962 I found 9 other instances Below is a table showing the results of buying at the close and holding for the next X days. (Click table to enlarge.)

The stats are quite impressive with the average trade gaining 2% over the next week and 3% over the next two weeks. The average winning trade posted 3.4% over the next week and 5.4% over the next two weeks. There is a positive expectation going forward for the next month. The summary stats don’t tell the whole story, though.

Let’s look at the dates along with some notes:

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.
11/1/78 – Turned tail immediately and headed south. Took over a month to get back to closing level.
10/20/87 – One day higher then 3 day pullback before bouncing back up.
9/1/98 – 3 down days then next leg up.
4/5/01 – 1 day 2.7% pullback then back 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.
7/28/02 – 1 day pullback then rocketed higher.

Additional observations:

The only one that didn’t add on to its gains at some point in the next week was 11/1/78.
The only one that didn’t trade below its large upthrust close in the next week was 5/27/70.
The remaining 7 pulled back between 0.5% and 4.1% at some point in the next 3 days.
The average pullback was 2.75%.
Five of the remaining 7 began their pullback the next day.

September 1 1998, September 24 2001 and July 28 2002, which are all on the list above are the 3 times the CBI spiked to 15 or higher while at a new low. They are the dates I mentioned last night.

The above analysis combined with the fact that the CBI remains high indicates to me there’s still some juice left in this rally. It also appears likely the market will look to digest these gains over the next 1-3 days and traders looking for short-term gains may be able to get a better entry point.

"Positive" Divergence of New Lows?

One statistical divergence I’ve seen some discussion of lately is the smaller number of new lows compared to the January bottom. Theory says that this is a positive breadth indication. Since less stocks are posting new lows, less stocks are in poor technical shape. Hence, although the price level of the observed index is near or below the previous swing low, the makeup of the market is improved. Supposedly this has bullish connotations looking forward.

Proponents of this kind of analysis can easily point to some instances where the divergence seemed to work beautifully. One nice looking example would be August 2004 bottom. The S&P 500 poked beneath the May lows but NYSE New Lows contracted. The market put in a nice rally after that.

I ran a test to see if a contraction of new lows on a swing lower for the S&P 500 was predictive of a rally. Basically I looked for the SPX to make a 100 day low while the highest number of new lows in the last 100 days was greater than the highest number of new lows in the last 10 days. The trade entry point for the study was above the prior days high and the exit was 20 days later. Going back to 1992 I found 10 instances. I’ve listed them below.

It appears to me this divergence worked well during bull markets (98, 99, 04, 06) and not well during the bear market of 2000 – 2002. Success would therefore seem to be attributable to factors other than the divergence.

October ’98 and October ’02 launched some very strong 1-month moves and it’s interesting that the divergence was in place at those times. Based on the magnitude of success of some of these rallies the divergence may therefore be notable. As a stand alone indicator I was unable to find predictive value using my fairly simple test.