Thursday, May 11, 2006

Relative Movement: A Different Way of Looking at Strength and Weakness

Today's market fell sharply, declining over a full percent. But what does that really mean? A one percent decline in a highly volatile market is fairly routine. In a low volatility market, such as the one we've had recently, a one-percent move is large.

One way to adjust for these volatility differences is to measure a day's movement in standard deviation units. What I did was create a moving 60-day window for SPY and calculate the standard deviation of daily market moves. I then calculated each day's movement as a multiple of that 60-day standard deviation.

It might surprise you that today's decline was a drop of 3.39 standard deviation units. Since April, 1996 (N = 2520 trading days), we have only had 86 such declines. So while it might seem as though today's drop was not huge, in relative terms it was quite a drop.

Since 1996, the day after a drop of 3 or more standard deviation units, SPY has been up on average .16 standard deviation units (46 up, 40 down), stronger than the average gain for the sample of .05 units (1311 up, 1209 down).

When we look at the most recent data, however, a different pattern emerges. Since 2003, we've had 26 drops of 3 or more standard deviation units. The next day, SPY has averaged a loss of .51 units (11 up, 15 down). From 1996-2002, the next day change in SPY after a big relative drop has been a rise of .45 units (35 up, 25 down).

Psychologically, we may respond more to the relative size of moves than their absolute magnitude. That reaction may be particularly magnified during low volatility market periods, leading to next day continuation of weakness.