Wednesday, April 04, 2007

A Follow-Up On New Highs And New Lows In The Stock Market

My recent post noted that, following a surge in the number of stocks making new five-day closing highs, we tend to see follow through strength over a three-session period prior to subsequent reversal at a five-day period. An alert reader wrote and asked if the same pattern applies to surges in the number of stocks making fresh five-day closing lows.

The answer is yes, but the time frames are different.

Recall that we're looking at a portfolio of 40 stocks evenly divided among and highly weighted within eight S&P 500 sectors. Going back to 2004 (N = 813 trading days), we've had 38 occasions in which the net number of stocks making new lows over new highs reached 25 or greater. We'll call that the "weak day".

The following day, the S&P 500 Index (SPY) broke below the low of the weak day on 26 of the 38 occasions, for an average drop of -.28%. Across the entire sample, the low of the current day actually exceeds the low of the prior day by an average of .03% (443 up, 370 down). That tells us that, in the short run, broad weakness tends to spill over into the next trading session.

Interestingly, however, if we look on a close-to-close basis, we find that the day after the weak day, SPY averages a *gain* of .12% (22 up, 16 down). That is stronger than the average one-day change for the entire sample of .03% (444 up, 369 down). This tells us that follow-through weakness the day after a surge of new lows tends to reverse by the close of trade.

If we look five days out, we can see strong evidence of a reversal effect, as noted in a prior post. Following the weak day, the market is higher on 30 out of 38 occasions, for a solid average gain of .74%. By contrast, the average five-day gain for the entire sample is .16% (462 up, 351 down).

Once again we see a pattern of follow-through weakness followed by reversal. Notice with the days of surges in new lows, however, that the subsequent weakness tends to evaporate more quickly and the reversal effect is more pronounced. This is an important distinction between strong rising and falling markets that has important implications for trade planning.