Stock Market Sentiment and Reversals: The Temporal Anchoring of Expectations

For this investigation, I'm working with two assumptions:

1) That market participants overall are naive trend followers: they ground their expectations in the latest price action. Thus they become most bullish when recent price action has been rising and most bearish when recent price action has been falling. As a result, sentiment shows a marked recency effect.

2) That market participants anchor their perceptions temporally, punctuating market action by the most convenient units of time: the day and the week. As a result, their perceptions of the recent past are especially influenced by what happened over the last day (particularly among daytraders) and what happened over the last week (particularly among swing traders).

When we put these assumptions together, we can infer that traders will tend to have the most bullish expectations when the last day and the last week have been rising in price. Traders will tend to have the most bearish expectations when the most recent day and week have been falling in price.

Because the bullish traders have largely followed their views and expended their capital, we'd expect market returns to be subnormal following a rising day and week. Because bearish traders have followed their sentiment and either exited the market or sold it, we'd expect market returns to be above average following a falling day and week.

Going back to 1990 (N = 2107 trading days), the average five-day price change in the S&P 500 Index (SPY) has been .025% (1109 up 998 down).

When the most recent day and week have been rising (N = 722), the next five days in SPY have averaged a subnormal return of -.27% (351 up, 371 down).

When the most recent day and week have been falling (N = 616), the next five days in SPY have averaged an above average return of .35% (346 up, 270 down).

This temporal anchoring of sentiment has been particularly pronounced since 2007, with the rising days/weeks leading to an average five-day loss of -.56% (55 up, 70 down) and the falling days/weeks leading to an average five-day gain of .48% (61 up, 35 down).

It is precisely because average traders are trend-followers in the near term, anchoring their market expectations to the most recent time periods and price action, that the stock market displays intriguing patterns of reversal. These patterns were noted in part by Connors and Sen in their research and appear to be operative to this day.

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