Thursday, October 18, 2007

What Can We Learn From Simple Price Relationships?

In recent posts, I've emphasized the importance of seeing relationships among sectors and markets. But how about price alone? Does past price tell us anything about future price?

First I went back to 1990 (N = 4467 trading days) in the S&P 500 cash index ($SPX) and examined next 20-day returns after the market had closed at a 20 day high or a 20 day low.

When the S&P 500 Index has closed at a 20-day price high (N = 763), the next 20 days in $SPX have averaged a gain of .48% (475 up, 288 down). When the Index has closed neither at a 20-day high nor at a 20-day low (N = 3319), the next 20 days in $SPX have averaged a gain of .75% (2028 up, 1291 down). When the S&P 500 Index has closed at a 20-day low, the next 20 days in $SPX have averaged a gain of 1.38% (261 up, 124 down).

We thus see subnormal returns after 20-day highs and superior returns following 20-day lows.

But let's look a bit deeper. Suppose we have a 20-day high in which price is also above its 200-day moving average. In that situation (N = 691), the next 20-days in $SPX have averaged a pretty normal .62% (439 up, 252 down). When, however, we've had a 20-day high in which price was below its 200 day moving average (N = 73), the next 20 days in $SPX have averaged a *loss* of -.98% (36 up, 37 down).

What that suggests is that a 20-day high in a market that has been in a longer-term uptrend is not necessarily a bearish event or even one with significantly subpar returns. Rather, it's when we have a 20-day high in the context of a market that has been in a longer-term downtrend that we want to consider the possibility of a (bearish) return to that larger trend.

And how about when we have 20-day lows? When we've had a 20-day low in the S&P 500 Index and we're above the 200-day moving average (N = 166), the next 20 days in $SPX have averaged a gain of 1.01% (118 up, 48 down). When we've had a 20-day low and we're below the 200-day moving average (N = 219), the next 20 days in $SPX have averaged a healthy gain of 1.66% (143 up, 76 down).

In short, we've seen the greatest upside returns when the market has made a 20-day low in a market that has been down over a longer time frame--a clear reversal effect. Even when we have a 20-day low in a market that has been up over a longer period, however, returns are still favorable.

Price may not tell us everything, but it does offer a few indications that can be of use to an intermediate-term time frame.

RELEVANT POSTS:

Momentum and Reversal Effects

Fading the Herd
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