Last week I posted a study on the intermediate-term significance of a lagging Nasdaq. The results suggested more downside was likely in the weeks and months to come. There was 3 criteria for the setup. Surprisingly, the 3rd criteria was not met last week. “3) The difference between the current NYSE/Nasdaq ratio and the 10-week EMA must be at its widest point in the last 5 weeks. (The red line must be farther below the yellow line than it has been in at least 5 weeks.)” Updated chart as of 2/29/08 below:

Does the late-week change to the indicator benefit the market? It doesn’t appear so. I removed rule three and just tested on rules 1 and 2:

1) The NYSE must make a new 5-week high this week. 2) The current NYSE/Nasdaq ratio must be at least 3.0% below the 10-week EMA. (The red line must be 3.0% or more below the yellow line.)

The market was shorted if the above conditions were met and covered X weeks later. $100,000 per trade.

The results – listed below – changed very little. When the NYSE is hitting new short-term highs while the Nasdaq is lagging badly, it normally means the NYSE will succumb to the will of the Nasdaq. Like the original study, the expectation over the next 1-10 weeks is negative.

I checked to see how the S&P 500 has reacted past times it finished down 4 months in a row. Going back to 1960 there have been 10 other occurrences with exactly 4 down months in a row. Of those 10 times, 5 finished higher the following month and 5 finished lower. The average winning month was 3% and the average losing month was 2.5%.

Looking at any time the market has closed lower 4 or more times, I found 21 occurrences. Ten finished the next month higher and eleven finished it lower. Average gain was 5.1% and average loss 4.5%.

The longest losing streak was in 1974 when the S&P 500 finished lower 9 months in a row.

Looking at consecutive lows on a monthly chart does not seem to provide any quantifiable edge.

Over the weekend I got an email from “Brian” – a regular reader. He wrote that he had read one time that when the S&P 500 closes down 1% or more on the last trading day of the month, the next day has had a strong positive bias. He went on to note that eight of the last ten times this has happened the month has started with an up day.

I’ve read other research in the past suggesting that the 1st day of the month had a strong seasonal bias and I decided this whole notion was worth exploring more.

Brian’s 8 for the last 10 result matched my data, and in fact the 1st day of the month has been positive 11 of the last 13 times going back to November of 1998. Looking back further, though, there was no apparent edge. Between 1960 and November of 1998 there was a 1%+ drop on the last day of the month 25 times. Thirteen times the market lost ground the next day and twelve times it gained.

If we eliminate the 1% requirement and look at instances when the last day of the month closed down at all I found the following:

Since 1960 there has been a 55% chance of the 1st day of the month then having an up-day. When you consider that the chance of ANY day over that period being an up day was about 53%, the edge doesn’t seem large.

I broke out the data looking at 1960-1995 and then 1996-present and found some interesting differences. From 1960-1995 the chance of a down last day being followed by an up first day was only 47%. Since the end of 1995, it has happened 74 times with 54, or 73% of them, showing a gain on the 1st day of the next month.

Looking at all 1st days of the month shows a similar picture. From 1960 through 1995 the 1st day of the month finished positive 53% of the time – perfectly in line with all days. Since 1996 the first day of the month has finished positive 66% of the time.

Studies of recent history would show an upside bias on the 1st day of the month. Long-term studies would not indicate a bias. I cannot explain what may have happened in the 90’s that would have caused this to occur. Therefore it is difficult for me to say whether the bias truly has changed or what might cause the bias to revert back to pre-’96 form. Traders that try and incorporate the so-called “1st day of month bias” into their trading should be aware that the bias did not always exist, and therefore at some point may cease to exist again.

One indicator I look at comes from Gerald Appel’s book “Technical Analysis – Power Tools For Active Investors”. It is a relative strength measure of the NYSE vs. the Nasdaq looked at on a weekly chart. Without going into great detail, 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. Whatever the reasons behind it, the indicator has been a pretty good barometer over the years. Mr. Appel suggests using a 10-week relative strength indicator to measure this phenomenon. This is what I’ve done in the chart below. The way the indicator works is as follows: When the red line is above the yellow line, the Nasdaq is leading the NYSE. When the red line is below the yellow line, the Nasdaq is lagging the NYSE. (Click to enlarge).

Since 1971, close to 100% of the market’s gains have occurred when the Nasdaq is leading rather than lagging. As you can see from the chart above, the Nasdaq has begun to lag badly. I decided to look and see how the market has performed under similar conditions in the past.

Using the NYSE composite as the “tradable” vehicle, I set up the following rules: 1) The NYSE must make a new 5-week high this week. 2) The current NYSE/Nasdaq ratio must be at least 3.0% below the 10-week EMA. (The red line must be 3.0% or more below the yellow line.) 3) The difference between the current NYSE/Nasdaq ratio and the 10-week EMA must be at it’s widest point in the last 5 weeks. (The red line must be farther below the yellow line than it has been in at least 5 weeks.)

If all three conditions are met, sell the market short on the close. Cover X weeks later. Results below:

As you can see, a Nasdaq lagging as badly as it is right now has been quite bearish historically. The bearish tendency carries through over a significant period of time as well (10 weeks.) If the Nasdaq could begin to assert a leadership role, that could help the current rally attempt greatly. If not, bulls better hope it’s different this time.

More bailout talk today led to another surge of buying. The major averages closed strongly positive on good breadth and increased volume. Technically notable is the fact that the triangle pattern in the S&P was broken to the upside. An argument could be made that the triangle broke to the downside on Friday and that break quickly led to an upside reversal. Based on the definitions in the studies I laid out last week, there was no break on Friday. The first breakout came today. In this case I’ll stick with my definitions because those are the ones that were used to develop the statistics. The minimum target based on those studies’ triangle measurements would be 1446.57. Of note is that over 70% of these patterns have failed to reach their target before dropping below the lower triangle line. In this case a failure would mean a move below 1327.04. It appears looking for an entry to fade this breakout may provide the greatest edge.

The surge the last two days which broke this market out has certainly been impressive. I looked back to see how the market had reacted following similar boughts of strong buying. Below is a table displaying how the market has performed near-term following two strong days of buying during a long-term downtrend.

Historically, fading these surges has provided a decent edge. As can be seen in the picture above, not all breakouts are good news. Between the 2-day surge and the triangle breakout study it appears the edge over the next few days is to the downside.

While the move down Friday morning may have violated trendlines some technicians drew on their charts, it did not signal a break for either of the triangle testing methods I laid out last week. For violations to be official I currently would need to see one of the following: 1316.75 broken on the downside for method #1, 1369.23 on the upside for method #1, or 1367.94 to the upside or 1327.04 to the downside for method #2. Therefore, as per the studies, we are still waiting for a break to look to fade. The studies on Thursday night suggested fading the breakout could be the highest-odds play.

While it failed to move the S&P 500 out of its range, the action Friday certainly wasn’t mundane. A late-day reversal led to a sizable upside surge – moving the indices from squarely negative to squarely positive. I decided to look and see whether past late-day surges had led to a directional edge over the days following. Looking back 30 years I was only able to find 22 other times where the S&P 500 gained over 1.5% in the last hour of trading. Results following those instances were mixed. Over the next one and two days the market closed higher 10 of 22 times. Over 3 and 5 day periods the market increased 14 times. Looking our further (10, 15, 20 days) results were close to a coin flip. The win/loss ratio in all these instances was close to 1 as well.

In other words – the late day surge on Friday seems to have no predictive value when looking out over the next few days. All it managed to do was put the market squarely back in the middle of its range. Traders with time-frames longer than intraday may want to continue to wait for a range resolution before getting aggressive.

The formation that everyone seems to be focusing on at the moment is “triangles”. The major indices are all making them and the media and blogging community have taken notice. The standard line is that triangle formations show a contraction of volatility. A break out of the formation can lead to a sharp move in the direction of the breakout. So the big question being asked is “Which way is it going to break?” To me a better question seems to be “What is likely to happen after it breaks?”

The profit potential of a triangle breakout is normally determined by subtracting the low of the triangle from the high and adding that to the breakout point. Triangles are one of those formations that are easier to spot on a chart than they are to program, but I attempted it two different ways.

I first looked at formations where the most recent swing low was higher than the previous swing low and the most recent swing high was lower than the previous swing high. A breakout was defined as a move outside the nearest swing high or low. The profit target was defined as the distance from the entry point plus (or minus for shorts) the highest swing high minus the lowest swing low. A “failure” was defined as a reversal through the opposite swing point in the triangle.

The second way I defined a triangle was a bit simpler. I looked at weekly bars and defined any two consecutive “inside bars” as a triangle. Here again I set a profit target using the biggest bar and defined a stop point as a move through the opposite end of the most recent inside bar.

In both cases the success rates were highly disappointing. Looking at all S&P 100 stocks over the last 15 years, method 1 posted a success rate of about 38% and method 2 a success rate of 30%. The success rate in the S&P 500 Index over the last 30 years was 30% for method 1 and 27% for method 2.

Some traders may still be tempted to play the breakout because the potential reward is higher than the risk. Even so, method 1 was only slightly profitable as gains outsized losses by a mere 1.03 to 1 without factoring in commissions or slippage. Method 2 showed net losses.

It seems to me that the best way to trade these kind of triangle formations is not to play the breakout. Since about 2/3 of the breakouts I tested eventually failed, I’d rather wait for the breakout to occur and then evaluate possible reversal areas that could offer a more substantial edge.