Do IBD Follow Through Days Provide A Quantifiable Edge? (Intro)

The S&P 500 currently stands about 11% below its October 11th highs. The rally attempt that began near the end of November officially failed last week as the November lows were undercut. Growth-oriented traders everywhere are now eagerly awaiting the next Investors Business Daily Follow Through Day so that they may more aggressively put their capital to work. The IBD Follow Through Day is a technical tool to help investors time market bottoms. My first introduction to the Follow Through Day was in William O’Neil’s book How To Make Money In Stocks. The Follow Through Day is both widely followed and widely accepted as an early signal of a market bottom – but does is really provide investors with a quantitative edge?

While their descriptions are sometimes inconsistent the basic concept and claims of the Follow Though Day may be summed up as follows:

1) After a significant market decline, rather than trying to pick a bottom, investors should wait for a signal from the major averages to let them know the market is likely to begin a new uptrend. This signal is the Follow Through Day.
2) A Follow Through Day is a day where one of the major averages makes a significant rise (currently defined as 1.7% – previously defined as 1%) on increased volume.
3) Follow Through Days may occur starting on day 4 of an attempted market rally. Follow Through Days occurring after day 10 are deemed less reliable.
4) There has never been a market bottom followed by a bull rally without one.

While at first glance the Follow Through Day seems straightforward, much of it is either vague or inconsistent. IBD says that the concept is backed by decades of research. Unfortunately, to my knowledge, details of this research have never been released to the public. It is difficult to duplicate this research because IBD is vague about important terms – such as what they consider a significant market decline to be and what would determine “success” after a Follow Through Day occurs. But just because vague terms and inconsistencies make the research difficult to duplicate doesn’t mean it isn’t worth doing. As you may be beginning to realize, I believe the subject deserves a significant amount of consideration. Rather than try and cover it all at once (and subject everyone to an incredibly long blog entry) I will be doing a series of reports over the next week or two to take an in-depth look at IBD Follow Through Days. In these reports I will attempt to answer such questions as:

1) Are Follow Through Days predictive of a new bull rally?
2) Has there ever been a bull rally without one?
3) Do they do a good job of picking a bottom (or do they frequently miss too much of the move)?
4) Do they work better after small or large market declines?
5) Do Follow Through Days occurring more than 10 days after a market bottom yield lower success rates?
6) Can I devise a successful trading system using Follow Through Days?

The market put in a strong reversal day last Wednesday. Monday is the first day that a Follow Through Day is possible. Will it provide investors with a quantitative edge? You’re going to find out…

…first installment tomorrow.