Buy The Market On Signs Of Capitulation

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Includes: IWM, QQQ, SPY
by: FiatFxWorld

Summary

January performance is worst in 50 years & confidence is understandably shaken.

One reliable indicator signals a high risk-reward buying opportunity.

The indicator delivered on average a 5.8% return over 20 sessions with a 93% win ratio.

It has been a nervous couple of days in the stock market as this month's performance stands at -9%. If the S&P500 index ended the month at this level, it would be the weakest January since my data starts in 1950. Whether you attribute the weakness to the devaluation of the Chinese yuan, weak commodity markets, global growth concerns, a spillover from weak credit markets or simply a correction after an extended period of complacency - we sure have seen a rise in volatility and nervousness in recent days. Many markets have broken uptrends and a number of markets are in bear markets, having fallen over 20% from the highs.

Given the above, it is worth highlighting that one reliable technical indicator is signaling a high chance of a bounce over the coming month. Indeed, given the cathartic price action yesterday, the bounce may indeed have started and the low may be in. After being down 3.7% intraday, the Russell 2000 ETF (NYSEARCA:IWM) ended the day in positive territory on a high-volume day - this smells of capitulation.

IWM daily Click to enlarge

The indicator in question - let's call it the down volume exhaustion indicator - uses the NYSE up-volume and down-volume series. In particular it captures instances of up-volume being extremely low relative to down-volume over a period of 14 days. When this indicator hits an extreme (below 2 standard-deviations) we are likely at or very close to a short-term bottom in stocks. For example it signaled a buy on the 2nd of March 2009, preceding the multi-year low in stocks on March 9th by 5 days. This and the other buy signals can be seen on the following chart marked with dots:
Volume Exhaustion Click to enlarge

A closer analysis of the data reveals 8 distinct clusters and a positively skewed return profile. Indeed only once would a trader have made a loss - and then a small one of 0.6%. All other 14 occurrences were positive (93% win rate) with an average return of +5.8% - a rather impressive result for any indicator.

volume exhaustion table

It appears that after the recent panic odds favor a bounce based on similar volume exhaustion signals in the past. The risk-return is favorable for a long position and further supported by a piece on a different indicator published earlier this week: A Bounce Into Month-End Is Coming As Signal Flashes Buy. The S&P500 ETF (NYSEARCA:SPY) and Nasdaq ETF (NASDAQ:QQQ) as well as ES/NQ futures may be appropriate vehicles for this trade.

Disclosure: I am/we are long SPY, QQQ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.