Sunday, October 14, 2007

Global Performance as a Gauge of Trader Psychology

My previous two posts have investigated sector performance and performance across asset classes as sentiment measures. In this post, we'll look at global performance as a gauge of trader psychology.

One of the most important issues in trader sentiment is whether market participants are primarily risk-seeking or risk-averse. If they are risk-seeking, they will gravitate toward the more volatile, but less established equities of the emerging markets (EEM). If they are risk-averse, they will prefer, in relative terms, the more stable and established U.S. large cap stocks (SPY).

As we can see from the chart above, from 2004 to the present, investors have had a good risk appetite for emerging market equities. Indeed, at the start of 2004, EEM was trading around 56 and SPY around 111. Today they trade at very similar prices.

One measure of risky sentiment is to compare the performance of EEM vs. SPY. Since 2004, when the ratio of EEM:SPY has risen over the past 20 trading sessions (risk-seeking environment; N = 645), the next 20 trading sessions in SPY have averaged a gain of .51% (407 up, 238 down) and the next 20 sessions in EEM have averaged a gain of 1.83% (436 up, 209 down).

When the ratio of EEM:SPY has declined over the past 20 trading sessions (risk-averse environment; N = 287), the next 20 days in SPY have averaged a gain of 1.07% (201 up, 86 down) and the next 20 days in EEM have averaged a gain of 3.28% (211 up, 76 down).

Indeed, when the ratio of EEM:SPY has risen by more than 5% in a 20-day period (risk-seeking environment; N = 172), the next 20 days in SPY have actually averaged a loss of -.37% (86 up, 86 down) and the next 20 days in EEM have averaged a loss of -.99% (83 up, 89 down).

On the other hand, when the ratio of EEM:SPY has declined by more than 5% in a 20-day period (risk-averse environment; N = 63), the next 20 days in SPY have averaged a strong gain of 1.74% (46 up, 17 down) and the next 20 days in EEM have averaged a whopping gain of 3.46% (42 up, 21 down).

In sum, returns have been more favorable over a one-month horizon when we've been in relative risk-averse environments than in risk-seeking ones. Once again, we see the dynamics of market sentiment at work: the relative performance of equities across the globe provides us with information about optimism and pessimism--and useful clues for the contrarian.

RELEVANT POSTS:

EEM and Speculative Sentiment

Split Personality in Emerging Market ETFs
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3 comments:

High Probability Trader said...

this pattern is seen even on smaller time frames such as weekly and daily. It seems EEM is like SPY but leveraged 2.5-3x.

st said...

Dr Steenbarger,
A quick review shows that the 20 day change in the ratio of EEM:SPY the last 24 days has been over +5% every day, yet the markets keep ripping higher. Granted no indicator works all the time, I'm wondering how you deal with mean reverting indicators when markets are in a straight momentum phase. The real key in knowing how and when to use any indicator seems to be a discretionary one.

Brett Steenbarger, Ph.D. said...

Hi ST,

Great point. Supplementing indicators such as EEM:SPY with momentum and strength indicators (like those covered in my Trading Psychology Weblog) is very promising and, in my experience, adds value.

Brett