Oct 11, 2010

Using Money Flow Index For Predicting Market Corrections

There are numerous indicators for measuring market strength. One of them has real predicting power. The Money Flow Index (MFI) is a momentum indicator showing overbought or oversold areas of underlying and strength or weakness of the trend. It is precise measurement because it is volume-weighted of the strength of money flowing in and out of security. It is calculated dividing positive money flow to negative money flow. Readings are from 1 to 100, over 80 showing overbought area, under 20 – oversold.

 The chart shows movement of the broad US index S&P500 compared to MFI. Money flow index had values above 80 just before every major correction for last year. We’ve seen two significant corrections – one in mid January, second – April and now we are in the hot spot as MFI forming same pattern just like previous two times. It is no coincidence that market sell offs occurred just 2-3 weeks after the beginning of the earnings season. At the moment we are entering Q3 report period. Usually investor mood is positive before companies post results and everybody is buying in the wings of hope for better earnings. After the picture is clear some are cashing profits. Pattern is known as “buy the rumor sell the fact” trading. In this situation MFI index is inflated to 90’s before declining, despite of continuing market growth. Such a divergence is seen in the moment. After reaching 94.4 on Sept 21 MFI has dropped while S&P500 was still climbing. One should expect market correction 2-3 weeks from now considering mentioned above and previous two patterns. Of course there is exception as seen in April market fall as MFI entered overbought area almost 2 months before market dropped. This could be explained with over optimistic view of the market and expectations for V-shaped recovery at that time. It is not the case right now. How big correction might be depends on earnings report surprises but positive scenario could be seen here.

 Source: StockCharts.com

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