Why I'm expecting a short-term bounce

It has been a particularly brutal week for the markets. Since the Federal Open Market Committee announcement on May 10, 2006, the S&P 500 has been a freefall.

While the day trading has been very exciting and profitable, my 401K’s and IRA accounts are going through a drawdown. Is it time to exit my stock positions and go to cash? I decided to take a longer-term look at a chart of the S&P 500 and see what an analysis of past market conditions might tell me.

I want to preface the rest of the article with a several caveats.

1. For this analysis I am using a proprietary system developed the TradingMarkets Research team. This team, led by Larry Connors, released this system in April of 2004. The system is called the RSI 25 Explosion system. Since it is a proprietary system, I cannot divulge the details of how the buy signals were generated.

2. While the system has had impressive backtesting results and winning trades since the release of the system, there is no guarantee that future results will be same.

3. I did “tighten up” the system parameters to make the effects of the sell off and subsequent volatility even more extreme. This would create signals that happened less often because the market conditions occurring now have happened less often.

I used a weekly time frame. I did the analysis using the $SPX.X (SPX | Quote | Chart | News | PowerRating) symbol in TradeStation. So what did I find? Since the week ending August 20, 2004, there have been two times that we have had similar market conditions. These market conditions generated 2 buy signals by the slightly modified RSI 25 system. You will see these market condition marked by “buy” signal arrows. If you remember back to the time, both of the pullbacks were rather dramatic. Both of the signals were exited with a profit 2 to 4 weeks later when an exit signal was generated.

If we close on Friday May 19, 2006 near the lows of today May 18, 2006 and the volatility levels of the VIX (VIX | Quote | Chart | News | PowerRating) stay at a similar level, then we will have a buy signal generated for Monday morning.



Again, I would like to stress that this analysis may prove to be incorrect. On the other hand, with PowerRatings generating the extreme numbers of 9 & 10’s, this is just another indication that the market may bounce soon. Ashton has written several informative articles on the use of PowerRatings as a market-timing tool. If I am going to exit my 401K and IRA stock positions, I might want to sell into strength, rather than panic at this point.

If you would like to discuss the methods of how the buy signals were generated, I can be contacted at johne@tradingmarkets.com.

Best Regards and Great Trading

John Emery