Short-term Outlook (1-5 Days):  Neutral  From May 25, 1049 SPX

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Equity Indicators - Updates and Extremes

Average Directional Index

I keep the number of technical indicators I watch to an absolute minimum.  That doesn't mean there isn't value in some of them, it's just that watching too many tends to create more problems than it solves.

A subscriber asked about one in particular, though, and it's throwing off an interesting reading.  The ADX indicator recently moved to an exceptionally high level, one that has been historically meaningful.

I don't want to delve into the mechanics of the ADX when a simple web search will turn up plenty of background (click here for an adequate one from Stockcharts.com).  As a one-second introduction, the ADX measures the strength of the current trend, using a default look-back period of 14 trading days.

According to Stockcharts.com, when the ADX rises above 40, it indicates a strong trend.  What they don't mention, however, is that by the time it reaches that level, the trend is most often about to end, at least temporarily.

No need to take my word for it, though, let's just go back to 1928 and look for any time the S&P 500 closed at at least a three-month low (so we know we're looking at downtrends here) and the ADX crossed above 40.

The short- to intermediate-term following these signals were extremely positive, up 82% to 86% of the time, and with exceptional average returns.  The only real failure was in 1962 when we saw a short-term bounce and then a roll over into a major decline.

Overall, during the following month the median maximum loss was -2.7%, while the median maximum gain was +6.5%, more than twice as large.

It was awfully rare to get this signal during a bull market, objectively defined as a rising 200-day moving average on the S&P 500.

Here they are, culled from the table above:

Every time, the S&P rose over the next week.  Again, that 1962 occurrence pops up, so there was that false signal.  In 1969, stocks bounced for a couple of weeks and then sunk to a new low, so that one too was only successful in the short-term.

Overall, though, over the next month the median maximum loss was -1.8%, while the median maximum gain was +4.1%.

Pretty positive stuff.

AAII Bull Ratio

One of the more curious sentiment developments over the past couple of weeks is the fact that individual investors weren't becoming overly concerned.

A major indication of that is the American Association Of Individual Investors survey, which remained solidly neutral despite the market drop.  No longer. 

This week, the Bull Ratio (Bulls / (Bulls + Bears)) declined to 37%.  While it has certainly been lower, historically this is on a par with other readings of extreme pessimism, particularly during a bull market.

Since the survey's inception in '87, there have been 99 other weeks with a similarly low or lower Bull Ratio.  A month later, the S&P was positive 65% of the time, averaging +1.3%.  Three months later, it was up 78% of the time with a +3.7% average.

If we restrict the query to bull markets only (defined as an upward-sloping 52-week moving average on the S&P), then the one-month figures actually decline (64% positive and +0.5% average return) but the three-month picture brightens, at least in terms of consistency (82% positive and +2.7% average).

Post-Memorial Day Returns

I mentioned earlier this week that seasonally, the S&P seemed more likely to enjoy upside after Memorial Day than before it, due to the tendency to see weakness prior and strength following the break.

The edge isn't huge, and it has been less consistent lately, but just for shits and giggles let's check for any time the S&P 500 closed at a three-month low at some point in the week prior to Memorial Day, then buy at the close the day before the holiday and hold for the next week.

Nothing too spectacular, but there was a fairly consistent positive edge.  A couple of the exceptions were large, though, which mitigates the intrigue.

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