Sunday, January 15, 2006

Weak Stocks and Bonds - Continuing the Investigation

Yesterday's entry looked at strong days in the stocks since 2003 and found a tendency for near-term reversal, especially when bonds were also strong. That made me curious about weak days in stocks (SPX). Is the outlook following weakness different as a function of bond prices?

Since January, 2003 (N = 760), we've had 185 days in which SPX has been down by half a percent or more. The next day, stocks have risen on average .12% (112 up, 73 down), which is considerably stronger than the average rise of .03% for the remainder of the sample (310 up, 265 down). This is the pattern of strength following weakness that we've encountered before.

Once again I subjected the weak SPX days to a median split based upon bond price performance that day. When bonds were weak and stocks were weak (N = 93), the next day in stocks averaged a gain of .26% (62 up, 31 down). When bonds were strong and stocks were weak (N = 92), the next day in stocks averaged a loss of -.02% (50 up, 42 down). Again, this is counterintuitive. You would think that falling stocks and rising interest rates (falling bond prices) would yield weak stocks going forward. Just the opposite is the case: when stocks have been strong and bonds strong, we've had subnormal short-term returns going forward. When stocks have been weak and bonds weak, we've had above average short-term returns.

These patterns will be worth following, especially given the recent divergence between stocks (which have made new highs) and bonds (which have not).


nathanael said...

Dr. brett, I am wondering when you do your tests like the above, are you looking at the next days return as the next days open to close, or the current days close to the next days close? If it is close to close, i am curious if the above average return could be a result of intra day or overnight activity.

Brett Steenbarger, Ph.D. said...

Most the time, I'm looking close to close. You are correct to assume that, much of the time, the directional bias in a market occurs in the overnight session. That has meaningful implications for entering positions and risk management, of course. I can address this in future posts. Thanks for the question--