Wednesday, February 21, 2007

Persistent Strong Closes: The Personality of This Stock Market

Here's a little piece of trivia to chew on: Out of the last 15 trading sessions, we've traded below the prior day's closing price 10 times. On 13 of those 15 occasions, however, we've closed closer to the high of the day than to the low. In other words, we've typically had some degree of weakness during the market day, but--as on Tuesday--buyers have tended to step in and use such weakness as an opportunity to accumulate stocks.

How rare is this? Going back to 1990 (N = 4305 trading days), I could only find 34 occasions in which 13 or more days out of 15 finished closer to their highs than to their lows. Such persistent strong closes are rare.

One stretch of persistent daily strength occurred between October 20 and October 31, 2006. We had one occasion on June 6, 2005, two on February 15 and 16, 2005, and one on September 4, 2003. We don't see another such string until September, 1996. Sixteen of the occasions occurred between 1991 and 1993; none before that. If you recall your market history, you'll see that, over this period, strings of 13 or more days out of 15 closing nearer to their highs than lows have occurred only during bull markets. They have not occurred during 2000-2002, 1998, 1994, or 1990, for example. Indeed, we might even conjecture that part of what makes a bull market is not an absence of daily weakness, but the tendency for investors to pounce upon such weakness as value and an opportunity to buy.

This pattern of pouncing on weakness as an opportunity to buy has been occurring at even very short time frames. I took a look at the Odds Maker program from Trade Ideas and asked the question: What has happened over the past three weeks when you have bought a breakdown from the opening 15-minute range in the S&P 500 Index (SPY)? Such a break below the range of the first 15 minutes of trade has occurred on 10 of those days; buying those occasions and holding for the next 30 minutes resulted in 10 winners. The average win size was the equivalent of a little over 1 full S&P point, so that the trade would have netted about 11 ES points over that period.

So what has happened after periods of persistent strength when we've had 13 or more days out of 15 in which we've closed closer to the day's high than to the low? Ten days later in the S&P 500 Index, we've averaged a gain of 1.17% (23 up, 11 down). That is much stronger than the average ten-day gain of .37% (2508 up, 1797 down) for the entire sample. It would appear in this case that strength begets strength. One of the reasons for this is that the occasions of persistent strong closes have tended to cluster. We had a string of eight occasions in October, 2006; four in August/September, 1993; four in January, 1992; and six in January/February, 1991. Because such strings are common, we cannot assume that, because the market has been persistently strong on a daily basis, it is now due for weakness.

Every market, like every person, has a personality: a set of traits that define behavioral tendencies. This has been one facet of the current market's personality: persistence of strength. This investigation suggests that such persistence is rare, but--at least in the short run--it, too, tends to persist.


Larry Nusbaum said...

"Because such strings are common, we cannot assume that, because the market has been persistently strong on a daily basis, it is now due for weakness."

Like when you hear some Wall St. strategists explain why Small Caps are due to correct and Large Caps ready to take off, in fact, they have been wrong and the trend has continued for years.
Which makes me question the exact wisdom of "rebalancing". A sector or style can remain strong for years and there is nothing magical about January 1.
Haven't we heard about REITs and Small Caps supposedly correcting for years now? Kind of like we've heard about the end of the consumer....

Brett Steenbarger, Ph.D. said...

Great points, Larry; thanks. As a rule, unusual strength in markets tends to persist in the short run at the very least. We had a low volatility bull market in the early to mid 1990s and that really didn't experience a major correction until late in the decade. Investing would be far easier if the markets moved in regular, predictable cycles and you could sell highs and buy lows. No such luck!


b hong said...

Wonderful post Dr Brett. I was mindful of your many previous posts regarding regression to the mean and that two to three days of strength/weakness tended to produce contrary results over the nest few days.

As you point out, this is an entirely different animal and we need to distinguish horses from zebras. Due to your medical school experience, I'm sure that you understand the metaphore. For those who don't know, medical students are taught "when you hear hoofbeats outside, look for horses, not zebras." In other words, common things(diseases) being common, think sore throat before throat cancer!

To extend this analogy, most days of strength/weakness represent the thundering hoofbeats of horses. But OCCASIONALLY, a herd of zebras does wander by. Thanks for helping us to distinguish between the two.

Brett Steenbarger, Ph.D. said...

Thanks, Bruce, for the excellent analogy. Expect the horses, but be prepared for the zebras is wonderful trading advice!!


D TradeIdeas said...

Excellent article! It and a support IM today sparked another in our strategy session series. Thanks for the inspiration!

Brett Steenbarger, Ph.D. said...

Hi David,

Thanks for the link to the interesting strategy--