a breadth flip-flop

We witnessed an extreme flip-flop in market breadth late last week that’s worth noting given its historical significance. Days like Friday [1/20/06] are discouraging for investors holding long positions, given the complete reversal of Thursday’s relatively healthy day. Almost 2½ times more stocks rose on Thursday than declined. Then Friday came, and almost 2 ½ times more stocks declined than rose. The last time we saw the discouraging pattern of a 2-to-1 up day followed immediately by a 2-to-1 down day (using NYSE advance/decline figures) was on July 21, 2005. That was a notable day as the S&P had hit a new yearly high the day before on July 20. The market went on to enjoy a couple more weeks of gains before a deeper correction set in. That was the case most times this has happened in the past.

According to SentimenTrader, over the past 30 years, there have been 21 other cases where we saw these types of immediate up-down reversals in breadth. Two weeks later, the S&P was positive 17 times (81%) and posted an average return of 1.2% (it was positive 10 out of 11 times over the past decade). It wasn’t a free ride however—on eight of the instances, the maximum drawdown one would have suffered during that two weeks was more than -2%, including a couple of huge declines in September 1986 and October 1987 (after the crash).