Lack of Extremes

Bottom Line: Gap down opens in the Nasdaq 100 do not tend to last very long, regardless of the market environment. Curiously, however, when these gaps have filled the same day they were created, it has not been particularly bullish.

One of the things that has seemed remarkable about the market this year is its tendency to search out gap opens and fill them not long after. By “gap”, I am talking about an open that is materially different than the previous close. For example, I show that yesterday the Nasdaq 100 (NDX) closed at 1437.73 and today it opened at 1424.22, a gap down of 0.9%. I would define the gap as being filled once the NDX rallies back above 1437.73 (at any time, not necessarily just at the close).

So far this year, the NDX has had 30 days where it opened more than 0.5% below its previous close. A couple of years ago, I presented a table that showed what percentage of the time large gaps were filled within a certain number of days. Below, I have updated the table with a couple of modifications. For example, we are looking at gaps down of only 0.5% or more, and for comparisons sake I have also included the stats for the equivalent period of time for 2003 (a solid uptrend) and 2002 (a solid downtrend).

Nasdaq 100 Opening Gaps Down Through the first 196 trading days of the year
	Gap down of at least 0.5% filled within…
	Same Day	3 Days	5 Days	10 Days	30 Days	60 Days
2004 (30 days)	33%	70%	80%	90%	90%	97%

2003 (39 days)	56%	82%	90%	92%	97%	100%

2002 (73 days)	53%	70%	73%	78%	82%	82%

A few things stand out. First, there were more than twice as many gaps down in 2002 as there were in 2003 and so far in 2004, which isn’t a real surprise given the downtrend in place that year. Second, only a third of the gaps this year have been filled the same day – this is a marked change from 2003 and even 2002, when the majority of gaps were filled the same day they were created. But within 3 days, at least 70% of gaps were filled no matter what year we looked at. Overall, the data is quite consistent across the years. This increases the confidence if we want to say that nearly all gaps are closed within 30 days, whether we are in a bull market, bear market or trading range. Out of 142 gap down opens, only 17 were still not closed after 30 days during the study periods over the three years.

So if it has been unusual so far this year to see a gap down open filled the same day it is created, then today’s action could be considered unusual. In the late afternoon, the NDX rallied enough to peak above yesterday’s close, effectively filling the gap as far as I’m concerned. If we look at the other times that has happened this year, we are left with 10 occurrences. What’s interesting is that out of those 10 occurrences, 9 times the NDX gapped higher the next morning, and by an average of 0.5%. As I am writing this, the market’s reaction to INTC and YHOO earnings look like it will be about in line with that average.

However, these type of intraday reversals and gap up opens have NOT been a positive factor so far this year. Out of those 9 occurrences that gapped higher the next morning, the NDX was still higher after 3 days only 3 times, with an average return of -0.6%; after 30 days, only 2 were positive and the average return dropped to -1.5%; and after 90 days, every instance was negative and the average return slid even further to -4.7%.

Looked at one other way, if we simply sold short the NDX when it gapped up the next morning and held until the close three days later, then we would have had 6 out of 9 winning trades with an average gain of 1.1%. The biggest winner was 5.1% and the biggest loser was 1.3%. All in all, the pattern so far this year suggests that if the NDX holds its current after-market gains and gaps up tomorrow morning, it will not hold and we will in fact be lower a few days from now. Nothing is a sure thing of course, and the market’s dynamics are always changing, but I think this data is notable enough to suggest that it may not be the best bet to chase strength on the open tomorrow.

Bottom Line: Using a different methodology to view transport stocks’ likely returns next month, we see that crude does indeed have an impact.

I was asked a few times today to comment on an article by Mark Hulbert for CBSMarketwatch.com in relation to oil’s effect on stocks from one month to another. Specifically, if this relationship held with transportation stocks as I mentioned in the last comment.

Mr. Hulbert referenced a research paper that suggested that if oil rose 5% or more in a given month, then the following month would most likely be negative for stocks. I used this relatively simple methodology and tested it on the Dow Jones Transportation Average and the results were consistent with the findings of the study. Namely, if crude oil futures rose 5% in any given month, then the return the next month for the DJTA was -0.9%. Out of the 69 months where oil rose by that much or more, 42 times (about 60% of the time) the DJTA declined the next month.

The authors also suggested a simple trading system whereby you hold stocks, but if crude oil rises by 5% in any given month, then for the following month you sell your stocks and instead move into a money market account. Using the same logic for transportation stocks, we see the following equity curves:

Over the past 20 years, an initial $10,000 stake in the DJTA would have grown into just over $60,000 by the end of August. However, if we would have sold our transportation stocks and went into cash after any month crude oil rose by 5% or more, then that $10,000 would have grown into a much more robust $128,000 – more than doubling the return from a buy-and-hold strategy. However, there were several months in the late 1990’s when transportation stocks had huge one-month rallies even after crude oil rallied more than 5% in the prior month. Partially as a result of that, the drawdown during that time was greater for the trading system than it was for buy-and-hold. It is not a perfect strategy.

The methodology here was very rudimentary, and no adjustments were made for commissions, slippage, money market interest or the like. But the point is clear – by adjusting our expectations for next-month returns based on this month’s performance in crude oil, we can perhaps better anticipate how transportation stocks will perform next month. These results are stronger than the ones I presented last time, since the study methodologies differ. Still, I think it’s important to note this relationship and take it into account.

Over the past week and a half, there has been a real lack of subjects to talk about from a sentiment perspective. I’ve scanned our universe of models, indicators and data several times over and everything that comes up has either already been discussed and hasn’t changed, or there is just nothing to say about them. As I noted last time, when we have this type of environment, I don’t really trust breakouts and breakdowns and prefer to fade short-term extremes. We got some of those this morning, with the put/call ratios spiking and the NYSE TRIN hitting 2.50. I feel that will continue on both sides for the time being, and will look to take the other side of whatever short-term overreactions we may get. As of today’s close, there aren’t any to speak of, but that may change as early as tomorrow.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.