Sunday, August 20, 2006

What Trend Research Suggests for the Coming Week's Trade

In a recent post, I raised anew the concern that trading strategies in the S&P 500 Index that are based on trend following (buying strength, selling weakness) have been notably unsuccessful. I attributed this, in part, to the expanded arbitrage trade between the futures and cash, between different futures products, and between futures and ETFs.

Let's see if this phenomenon affects S&P 500 Index ($SPX) expectations for the coming week.

The past five trading sessions have certainly constituted an upward trend, as we've closed higher each day. So let's go back to January, 1990 (N = 4190 trading days) and see what has happened after $SPX has made a five-day high in the previous session and made a five-day low five days prior (N = 729).

Four days later, the market was down by an average -.01% (371 up, 358 down). That is appreciably weaker than the average two-day gain of .14% (2314 up, 1876 down). If we limit the data to 2003-present (N = 153), the results are almost identical, with an average four-day change of -.01% and 76 occasions up, 77 down. I also note that, since 2003, when we've had an upward five-day trend, the returns over the next two sessions have been particularly subnormal, with an average loss of -.08% (72 up, 81 down). That is quite a bit weaker than the average two-day gain of .07% (2239 up, 1951 down) for the entire sample.

Think about what that means: Since 1990 (and during the recent bull market), traders have lost money on average when they have bought the market after a five-day period of upward trending.

Let's add a couple of limiting conditions, however.

First we'll look at five-day bullish trending periods that have also terminated on 20 day price highs (N = 489). That's what we have as of Friday's close. Now we see that the next four days in $SPX average a loss of -.07% (239 up, 250 down)--truly weaker than the average four-day change noted above. Another way of looking at this is that a five-day uptrend within a 20-day uptrend yields even weaker returns than five-day uptrends that do not terminate in 20-day highs (N = 240; average price change .13%; 132 up, 108 down). The more pronounced the market uptrend, the worse the returns going forward.

Finally, consider the VIX and what happens when our five-day uptrend occurs with a VIX below 15 (N = 269). Here again we see the pattern of subnormal returns four days out, with the average change -.01% (140 up, 129 down).

And when we have a five-day uptrend with a low VIX *and* a 20-day high (N = 188; as we saw on Friday)? Four days out, $SPX averages an abysmal -.11% (88 up, 100 down). Since 2003, that four-day return under those conditions (N = 61) has been -.27% (26 up, 35 down)!

Buying strength has lost traders money. Buying persistent strength has lost traders more money. Buying persistent strength since 2003 has lost still more money. I will not act upon this information this week in a mechanical fashion, but you can be sure that I'll be looking for sell setups where buyers lifting offers cannot move the market higher. As noted in my most recent post, I will be posting those intraday observations here during the new mid-morning updates. Also make sure you take a look at the Micropsychology Modeler results to be posted this evening on the Trading Psychology Weblog.