As of 08/20/2019
  Indus: 25,962 -173.35 -0.7%  
  Trans: 10,006 -75.35 -0.7%  
  Utils: 834 -1.95 -0.2%  
  Nasdaq: 7,949 -54.25 -0.7%  
  S&P 500: 2,901 -23.14 -0.8%  
YTD
 +11.3%  
 +9.1%  
 +17.0%  
 +19.8%  
 +15.7%  
  Targets    Overview: 08/15/2019  
  Up arrow27,200 or 24,900 by 09/01/2019
  Up arrow10,700 or 9,550 by 09/01/2019
  Up arrow850 or 790 by 09/01/2019
  Up arrow8,200 or 7,400 by 09/01/2019
  Up arrow3,000 or 2,750 by 09/01/2019
As of 08/20/2019
  Indus: 25,962 -173.35 -0.7%  
  Trans: 10,006 -75.35 -0.7%  
  Utils: 834 -1.95 -0.2%  
  Nasdaq: 7,949 -54.25 -0.7%  
  S&P 500: 2,901 -23.14 -0.8%  
YTD
 +11.3%  
 +9.1%  
 +17.0%  
 +19.8%  
 +15.7%  
  Targets    Overview: 08/15/2019  
  Up arrow27,200 or 24,900 by 09/01/2019
  Up arrow10,700 or 9,550 by 09/01/2019
  Up arrow850 or 790 by 09/01/2019
  Up arrow8,200 or 7,400 by 09/01/2019
  Up arrow3,000 or 2,750 by 09/01/2019

Bulkowski's Countertrends

 

Imagine you're about to buy a stock. The Dow Industrials, Nasdaq composite, or S&P 500 index rise substantially, but your stock falls. Should you buy? What about the reverse situation, where the index drops but your stock rises? Is the stock worth buying?

This article discusses research to answer those questions.

 

Countertrend Summary

I learned two lessons from this research.

1) Stocks that dropped when the index climbed performed less well for about a year, on average. If a stock consistently drops when the market climbs then consider selling it.

2) Stocks that climbed when the index dropped substantially outperformed the index and their peers up to a year later, on average.

This suggests the following trading strategy.

One test showed that the setup lowers the failure rate and beats the market in two out of three trades (67% of the time).

Out of sample tests confirms a lower failure rate and substantially better performance.

Countertrend Methodology

The test below used 362 stocks with data that spanned from the end of the first bear market, 10/11/2002 to a year before the second bear market began, 10/10/2007, to capture an entire bull market. Not all stocks covered the entire period. I discarded trades if the stock was priced less than $5 on the day the S&P made its large move.

I found all days in which the close-to-close move was at least 1% in the S&P 500 composite (Symbol: ^GSPC). I also tested the Nasdaq composite and Dow industrials using 0.25%, 0.5%, 1%, and 2% values. I show the results of the 1% tests as an example of how the other tests performed.

Once I had cataloged the dates of big moves in the indices, I measured the close-to-close moves on the same days in stocks, plus the next day, week, month, 3 months, 6 months and 1 year later.

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Countertrend Results: Upward Moves

Table 1 shows the results of price moves that occurred on and after the day a large move occurred in the S&P 500 index (bull market only).

For example, the average move in the index was 1.5% higher than the prior day's close (the "Day+1" cell). Remember, the test required a move of at least 1%, so values above this are expected.

Stocks also moving up on the same day ("upward move, stock" row) were more volatile (higher beta) and they climbed an average of 2.0%. Those stocks with countertrend moves ("Downward move, stock"), meaning those stocks that fell, dropped an average of 1.1% on the same day.

The next day (Day+2), the index remained flat (all gains are measured from the close on the first day). Stocks following the S&P and the countertrend stocks both gained a smidgen.

Look at the far right column. A year after the initial rise in the S&P, the index was 15.6% higher, the stocks that followed the same trend (meaning they were up at least 1% on that first day only) were up 20.8%, and the countertrend stocks were up a similar amount, 20.7%. The countertrend stocks took a long time to recover but by years' end, the performance was similar.

If you consider that the stocks dropped 1.1% initially when the index climbed and add that move to the 1 year result, we get a 21.8 percentage point change. That beats the average of stocks that trend.

Table 1: Countertrend Moves
Bull Market Day+1  Day+2  Week  Month  3 Months  6 Months  1 Year 
Upward Moves
Upward move, index1.5%1.5%1.7%2.7%4.9%8.6%15.6%
Upward move, stock
(trend followers)
2.0%2.2%2.3%3.6%6.6%11.5%20.8%
Downward move, stock
(countertrend)
-1.1%-0.8%-0.8%1.0%4.3%9.5%20.7%
Downward Moves
Downward move, index-1.4%-1.2%-1.0%0.2%2.5%7.0%14.2%
Downward move, stock
(trend followers)
-1.9%-1.9%-1.6%-0.3%2.6%8.6%18.2%
Upward move, stock
(countertrend)
1.1%1.2%1.5%3.2%5.7%13.1%24.6%

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Countertrend Results: Downward Moves

What about those stocks that move up when the index drops? The next series of rows ("Downward Moves") shows the results.

Again, I was looking for a move of at least 1%, a drop in this case, in the index. The average drop was 1.4% in the index, the stocks that also dropped fell 1.9% (trend followers). Those that climbed (countertrend) rose an average of 1.1%. The next day, the index and countertrend stocks climbed, but the trend followers remained steady. At the end of a year, the S&P was up 14.2%, the stocks that closed lower initially were up 18.2% and the countertrend stocks were up a massive 24.6%. Nice!

The lesson from this is that stocks that close higher when the market drops (countertrend stocks) tend to soar further than the others (trend followers) over the next year.

Just because a stock rises on a day the index falls at least 1% is not the cause of the stock climbing 24% a year later. Other factors are involved. There are reasons why the stock went against the market trend and outperformed. The countertrend price change we see is just investor enthusiasm for what they believe is a company that will do well in the future.

Countertrend Trading

Let's discuss the 24.6% gain from stocks in a bull market when the index drops. I found 5,291 samples out of 31,658 trades that were countertrend. The median gain of the countertrend trades was 25.4% (compared to the average of 24.6%). This compares to a median of 19.5% for the trend followers (those stocks represented by "Downward move, stock" in Table 1).

Sixteen percent of the countertrend trades lost money if sold at the end of one the year compared to 22% for the trend followers. So the countertrend trades are lower risk.

Using the 13.0% median of the S&P 500 composite as the benchmark (since we want to beat the overall market), 67% of the countertrend trades beat the index after holding for a year.

Thus, you can lower the risk of a failed trade and boost the return by buying stocks that rise on the day the S&P 500 composite drops by at least 1% and holding for a year.

Here is the setup for this trading strategy.

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Countertrend Out of Sample Tests

I tested the countertrend setup mentioned above using 223 stocks and bull market data (after the end of the last bear market, 3/7/2009 to 11/18/2013).

The countertrend stocks showed that 23% lost money after holding for a year compared to losses of 28% for the trend followers. Fifty-six percent outperformed the S&P 500 composite during the same period. The average gain of countertrend stocks was 22.3% (median 18.7%) compared to 16.3% (median 14.2%) for the trend followers.

In short, this bull market was not as robust as the mid 2000s, but the countertrend strategy still outperformed with lower risk.

Countertrend Trading Setup

In 2016, I worked on implementing a trading setup using bullish countertrend stocks. When the index fell, I wanted to buy stocks that closed higher on that day.

Sadly, I couldn't get it to work well enough for my taste. Maybe you can find something from this research.

I tried the following against the S&P 500 index...

What I felt was the best setup was this.

  1. Wait for the index to drop at least 1% on a given day (let's call this the big drop day).
  2. Look for stocks in the month prior to the big drop day to have at least 2 bullish countertrends.
  3. For the countertrend stock, compare the closing price a week after the big drop day to the close on the big drop day. If the stock is still higher, buy at the open the next day. This improved trading results by making sure the stock was trending higher.
  4. Use an 11% trailing stop loss
  5. Remain in the trade if a stock continues to have at least 6 countertrend moves each month. If not, sell at the open the next day. Remain in the trade if the index did not drop at least 6 times (because there we not enough countertrend days).

I used bull market data from January 1990 to January 2016. I found 1,969 trades made an average profit of 3.4% each, but the median profit was a loss of 2.6%. The average hold time was 58 days and the system won 44% of the time.

I found that this worked best in years like 2003 when the index dipped and then made a sharp rise. So you need volatility followed by a trend for this setup to work.

Countertrend Test Data

These two spreadsheets (a zip file of 767kb) contain the results from the above tests. Maybe you can find something in them that I missed.

-- Thomas Bulkowski

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See Also

 

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Chart Patterns: After the Buy Getting Started in Chart Patterns, Second Edition Trading Basics Fundamental Analysis and Position Trading Swing and Day Trading Visual Guide to Chart Patterns Encyclopedia of Candlestick Charts Encyclopedia of Chart Patterns 2nd Edition Trading Classic Chart Patterns

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