Saturday, December 10, 2005

Milking Another Pattern: Momentum and Midcaps

Well, before we explore pure price patterns, let's take a look at yesterday's momentum pattern applied to the S&P Midcap (MDY) stocks. We noted earlier that MDY has been a superior trading vehicle to its larger cap counterparts: it is trending better and displays superior volatility. But does it extract greater returns from the momentum pattern?

Once again the analysis looked at daily data from July, 2003 through November, 2005 (N = 608). The average three-day change in MDY during that period was .21% (361 up, 246 down). When Demand (number of stocks trading above their 20 day volatility envelopes) exceeded 500 (N = 78), the next three days in MDY were up by an average .42% (51 up, 27 down). When Demand fell below 140 (N = 83), the next three-day change in MDY was up by .45% (54 up, 29 down). Just as with SPY--but to a greater degree--the market outperforms three days later after upside momentum is either very strong or very weak.

It is interesting to look at the returns in the three-day MDY when momentum is moderate (N = 446). The average change of .13% (256 up, 190 down) is quite modest relative to those strong and weak upside momentum occasions.

Here, too, we see no edge associated with the Supply statistic (the number of stocks trading below their 20 day volatility envelopes). This occurred also with SPY, but not so dramatically. I'm not sure how to explain this, but what seems clear is that upside momentum--its presence or absence--is what matters in the near term. The absence of strength, rather than the presence of weakness, is most predictive. Perhaps this is a pattern associated with bull markets. Might it be different in a bear environment, where Supply would be the essential element? It's an interesting conjecture.

For now, however, we've seen two patterns now: TICK (short-term sentiment) and Momentum (Supply/Demand) that provide an edge when values are strong and weak. Moreover, we've seen that this edge is greater with a superior trading vehicle. Trading the right patterns with the right instruments does indeed appear to be helpful to performance.


Ryno said...

Can you infer any market psychology characteristics that explain ths observation?

Greg Lepiaf said...

Hi Brett and Paulo

Interesting to compare various indicators with markets. Certainly the "what" is as important as the "how". But why the S&P 500 and the MDY ?

If we want to compare the behavior of one indicator - eg momentum - in a market with low volatility with respect to a market with large volatility, why not compare the most extremes in order to get the clearest signal (if there is one) ? For example the S&P 500 vs the SOXX (I have not checked if this one is the most volatile), or among the 10 sectors of the S&P choose the one with lowest volatility vs the one with the highest…

The idea being always to choose the most extreme cases to well separate the effects.

In connection to Paulo's comment :
The DOW has effectively its lowest volatility but the RUSSELL 2000 has an intermediate volatility, lower than the volatility of recent years but still much larger than some more years ago.

Also low volatility does not necessarily bode bad for strategies. I had strategies for the RUSSELL going very well both for years with low volatility and for years with high volatility and which are hit this year although the volatility is in the middle range. Other phenomenon than the variation of the volatility have entered in the behavior of the index hitting my strategy.

Brett Steenbarger, Ph.D. said...

Thanks, Ryno and Greg, for the comments and questions.

I agree with Greg that there are many market indices that we could use for these analyses other than the ones chosen. SOX (or SMH) is certainly a great candidate, and I'm sure I'll get to it. I like using the S&P 500, Midcaps, and Small Caps because they are truly separate stock universes.

The comment that low volatility does not necessarily bode badly for trading is absolutely true. In fact, I tend to make more money in low volatility markets simply because I stay on top of the volume-weighted average price and fade moves above and below that level.

In terms of market psychology, Ryno, I'd say that the psychology of rises is different from the psychology of declines. When people are attracted to something, they approach it more gradually; when they're scared, they bail out more quickly. These differential dynamics create separate price paths following strong rises and declines. That, at least, is my best assessment of the whys and wherefores. Thanks again!