In order for longer term uptrends to be sustainable 2 conditions are necessary: 1) the up days are not substantial enough to make the slope unsustainable and 2) the market needs to consistently gap down to close up. The first condition assumes that there is a sustainable slope for which a security, market or commodity can increase or decrease at for an extended period of time, without requiring additional significant catalyst or corrections. The second condition assumes that given the first condition, the only way the second condition is possible is through gapping down to close higher or gapping up to close down (depending on the overall trend). Empirically, the is a positive correlation between the gaps and the close, but there are not sufficient observations to conclusively conclude this is always true. For example, the data on index gaps only exists for the last 6 years. Since this data begins after the last recession, I do not feel like it is fully representative of the true nature of the markets. Additionally, markets evolve, meaning one should weight more current trends higher. Anecdotally, this trend holds true since about summer 2008 (which is when I started noticing the trend). In the early stages of a trend, the correlation is in fact positive, supporting the empirical data. However, because those trends are longer and more prominent they bias the empirical study. As the trends matured, the correlation switched from positive to negative. This appears as a necessary condition for the trend to be sustained for a pronounced period of time. Finally, as the trends concluded, the correlations were almost always consummated by very strong positive correlation. This as well is explainable.
If an uptrend is just beginning (we will use the current uptrend that started in early March as an example), the correlation is positive, but not large in magnitude. This does not imply that the gaps cannot be of large magnitude, but typically they do not continue at such levels. After the trend has continued for some time, it is necessary that the gaps become negatively correlated with the closes. This happens because by gapping down the markets can continue to trend in the current direction and not outpace the sustainable slope. If the slope becomes unsustainable, by definition, a correction or retracement will occur. As the trend reaches its conclusion, the gaps become strongly correlated and have great magnitude. This happens because the slope of the trend has become unsustainable. Using the current uptrend as an example, when this trend is nearing its conclusion, the gaps down will be consistently 1 standard deviation or more away from the mean. Put more simply, the gaps in the DJIA will be in excess of 80 points. If not, the gaps are not predictive as they are not significantly different from the mean. In a bull market, two standard deviations ranged on average from -30 to +30.
The purpose of this explanation is to comment on the current uptrend. Before AT&T , Boeing and Wells Fargo reported earnings this morning the markets were looking to gap down with significance. However, because the news moved the markets significantly in the direction of the trend, it leads me to believe the trend is not in its mature stages yet. In fact, the increased volatility in the futures suggests that the opposition to the current trend are not truly convinced either.
Another trend involving the gaps and their predictive power revolves around the foreign markets. It is a common joke in the dorm that I am a machine because I willingly sacrifice sleep in order to watch the markets. As a result, I am generally awake when Europe opens. For instance, last fall when the markets were overrun with fear, I returned approximately 60% in the four month ending December 2008. I am not attempting to justify my returns or suggesting that simply watching the markets for an increased number of hours above your normal time will by any means improve your returns. I am saying that by observing the markets reactions worldwide that I ws able to understand and be more in tune with market movements. During the six week period where the fear was at its highest, I rarely slept more than two hours at night. Because of this obsessive behavior, I was able to notice some important patterns in regards to the foreign markets. The first pattern is that there are two major periods when the U.S. Equity futures have the largest move. The first period is when Asia opens, and the second period is when Europe opens. This makes intuitive sense in that at these two time periods, the largest amount of information is being priced into the markets. But even more insightful than this observation is the observation regarding the magnitude of the move of the overseas markets. If Asia was hit hard by a negative shock, and Europe felt the effects, but not to the same extent, it was almost non-existent by the time the U.S. Equity markets opened. However, this is not to say that the effects were not reflected in the U.S. equity futures.
Here is where understanding the gap patterns applies. If the futures were not suggesting a significantly different outcome than the current trend, the trend generally continued. This means that if the trend was higher, the gap would have to be significantly lower in order to confirm a reversal. This is consistent with the anecdotal evidence I observed, and possibly the empirical evidence. It is only possibly supported by the empirical evidence because I have not been able to review the information since understanding the potential cause of the disconnect between anecdotal and empirical evidence. During the time I’ve been writing this post, the DJIA future have gone from -60 to -31 (after the announcement of AT&T, Boeing, and Wells Fargo), and are now -75 (as Morgan Stanley announced worse than expected earnings, missing the Street’s estimate). Again this increased volatility supports my claims, and if we close higher again today, the uptrend will be confirmed. However, since Monday’s futures were greater than -100, another 1 or 2 days of similar action, before Wednesday of next week, will challenge the current uptrend. The reversal is beginning if the gaps get progressively larger and more pronounced. For instance, if we see the markets gap down today about where they are (-69 now), it will require another 2 days before Wednesday of significant gaps lower. We will need another one close to the size of Monday’s gap in addition to one in excess of -100 (preferably in the -120 to -150 range) to suggest a threat to the uptrend. The futures are improving from the lows after the MS announcement, which illustrates resiliency and or lack of conviction from the bears.