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.

In Larry Connors’ book “How Markets Really Work” he devotes a chapter to “Up Days In A Row vs. Down Days In A Row”. He looks at how the market has performed after it has moved in one direction for 1, 2, or 3 days in a row. Because of the long-term upward drift of the stock market, very few of the studies published in the book show much of a negative tendency. One situation that showed a negative tendency over the following 1, 2, and 5 day periods was when the market was trading below its 200-day moving average and had posted three higher closes. (This happened today.)

The book looked at data from 1989-2003. Over that period the following results were shown:

After the negative inside day on Friday, the S&P refused to sell off hard and even posted a decent gain today – breaking its recent streak. Perhaps this may signal a change in character from the downtrend since the October highs. Traders may not be looking to leave the party every time there’s a pause in the conversation.

Speaking of pauses, have you noticed how the price range has been tightening? The range over the last 3 days has been the tightest of any three days since December. Even more interesting to me is that over the last 13 days, the high-low range the S&P 500 has traveled has barely exceeded the range it traveled in the one day prior to that. The SPY on January 23rd had a range of $7.35. Since then the total range has been $7.88.

Looking at the S&P 500 cash index I went back to see other times the market traded in a range nearly as tight relative to one bar over a 13-day span. The parameter I used was that the range of the last 13 days had to be within 115% of the range of the 14th day back. I found 31 other occurrences going back 30 years. Twenty-five of those occurrences saw the market higher a month later. Only three times that I found was the range contraction followed by a break to the downside which led to significantly more selling. Those occurrences were August 1985, September 1990 and August 1998.

This study seems to be another example of what I’ve been seeing lately. Over the next several weeks risk/reward appears to favor the upside. Even this contracted range has some serious volatility, though, so risk should not be underestimated. Good timing and proper (reduced) position sizing appear key.

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On another note, I was pleased to have my recent post on leadership breadth appear in this week’s Festival of Stocks along with many interesting columns from other bloggers.