Sunday, October 15, 2006

The Trajectory--Not Just the Trend--Is Your Friend

In a recent post, I showed how markets that have been extended to the upside aren't necessarily "overbought" and ripe for decline. Strong momentum rises have better odds of persisting over the next time frame than rises with weak momentum.

Here, we'll take a different look at the data. Going back to 1990, we're examining periods of time that, like the present, are up solidly over the past 60 days (between 7.5% and 11.5%; N = 490) in the S&P 500 Index ($SPX). When we've been so strong over a several month period, are we due for decline, or are we in an uptrend that's likely to persist?

To examine this question, I broke down the strong 60-day periods into two groups. The first group was also strong on a 20-day basis (like the current market), rising more than 3% over that time (N = 218). The second group was weaker on a 20-day basis, rising less than 3% (N = 272). Thirty days later, $SPX was up by an average of 2.30% for the strong 20-day group (163 up, 55 down). That is considerably stronger than the average 30-day gain of 1.08% for the entire sample.

Conversely, when we were up solidly over 60 days, but relatively weak over the most recent 20 days, the next 30 days in $SPX averaged a gain of only .97% (163 up, 109 down)--no edge whatsoever with respect to the entire sample.

What that suggests is that it isn't just a market's rise that leads to favorable price expectations, but the trajectory of that rise. This fits with the findings regarding momentum persistence.

One more slice of the data:

When we've had a strong 60-day period *and* the most recent trading day is a 60-day high (as is the case at present; N = 169), the next 30 days in $SPX have averaged an impressive gain of 2.31% (127 up, 42 down). When the most recent day hasn't been a 60-day high, the next 30 days in $SPX have averaged a gain of 1.17% (199 up, 122 down).

Conclusions? Here's two:

1) Just because we've been up strongly over a several month period doesn't mean we're ripe for decline. Overall, following a strong 60-day rise, the market has gained an better-than-average 1.56% over the next 30 days (326 up, 164 down).

2) The journey is as important as the destination. Given a strong 60-day rise, we see better returns on average when the most recent price action is strong. This is one reason I include many measures of recent market strength in the Trading Psychology Weblog.

Can the market tank after a strong 60-day high? Absolutely. It occurred in July, 1990; February, 1997; January, 2002; and April, 1999. Is it the norm? Not at all. When we've made a 60-day high in a strong market, the next 30 days have shown positive returns 75% of the time.


Deborah said...

I think the best thing to do is to read the financials of the stock you are thinking about buying.

Purchasing is a micro perspective and this is macro analysis.

The stock market is run on greed and fear, stick to looking for undervalued because of those dynamics and overall you come out ahead.

Brett Steenbarger, Ph.D. said...

Hi Deborah,

You've touched upon what I see as an essential difference between investing and trading. The investor is looking for mispriced assets to move closer to value over time. Reading the financials, as well as keeping on top of the economy, is essential to the investor. The trader, on the other hand, is pursuing very short-term shifts in supply and demand that are relatively independent of macroeconomic and fundamental factors. There is much to be said for the strategy of looking past the trading noise and focusing on situations in which assets are mispriced relative to research-based models of value. Thanks for the note.


Glen said...

Brett, there's one more view I would like to see, that being the results in the 30 day trace period if the historical two month period occurred during strong seasonality (November to April), vs weak seasonality (May through October). The current rise has occurred during a normally weak period. One could make a case that the next 30 days will be very strong due to the boost from entering a seasonally strong period; one could also make the case that the current unexpected rise has simply 'borrowed' from the future.

Brett Steenbarger, Ph.D. said...

Hi Glen,

You make a very interesting point, and one that's worthy of research: Might market patterns test differently based on seasonal factors? For the longer-timeframe trader, this has considerable implications. Thanks for the note and creative idea--