Chart of the Week February 7, 2004

Chart of the Week – February 7, 2004

Brett N. Steenbarger, Ph.D.

Here is what the Research Note from 2/6/04 had to say after several days of corrective market action:

Note that when price doesn't budge on high buying or selling pressure, the resulting inefficiency often sets up a short-term move counter to the buying or selling. The Efficiency Index has been rising steadily, suggesting that we are having difficulty making new lows on selling bouts. This pattern, combined with an upside breakout in prices, would set up a nice short-term uptrend.

In that morning’s trading, a tepid jobs report led to some early selling, with prices and the NYSE TICK remaining well above their prior day’s lows. That meant two things: Selling was drying up, and what selling there was could not move prices lower. Such inefficiency generally precedes a change in trend. Sure enough, the early weakness was followed by a breakout to the upside, which triggered strong buying through the day.

The chart below captures how upside efficiency was rising even as the market was bottoming. The breakout in the Efficiency Index (blue line) preceded the price breakout (red line) in the market. This pattern is a very reliable indication of trend change.

Recall that the Efficiency Index is a measure of the price action that results from a rise or fall of one unit in the NYSE Composite TICK. An efficient market gains or loses many points on a rise or fall in the TICK. An inefficient market generates extreme TICK numbers with relatively small price change. In general, trending moves begin with very high efficiency and end with very low efficiency. Mapping the trajectory of efficiency allows for a projection of the potential duration and extent of a market rise or fall. Downside efficiency in the example below waned quite quickly, suggesting that this was to be a short-lived correction.

It is generally not a great idea to be short a market that is gaining upside efficiency, or long a market that is expanding downside efficiency. The highest probability swing moves can be found after overbought or oversold markets reverse on high efficiency.

I cannot emphasize enough the value of research such as this to tilt the odds in your favor.

Brett N. Steenbarger, Ph.D. is Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. He is also an active trader and writes occasional feature articles on market psychology for MSN’s Money site (). The author of The Psychology of Trading (Wiley; January, 2003), Dr. Steenbarger has published over 50 peer-reviewed articles and book chapters on short-term approaches to behavioral change. His new, co-edited book The Art and Science of Brief Therapy (American Psychiatric Press) is due for publication during the first half of 2004. Many of Dr. Steenbarger’s articles and trading strategies are archived on his website, .