A number of traders have commented to me on how choppy the market conditions have become. A strong movement seems under way, and then it just as strongly reverses.
As a way of looking simply at recent trading conditions, I went back to the start of 2007 and investigated three-day returns as a function of the prior three-day returns. Specifically, I looked at what happens when the market is up jointly on a one- and three-day basis (uptrending) and when it is down jointly on a one- and three-day basis (downtrending).
When the S&P 500 Index (SPY) has been up for the past one and three days, the next three days average a loss of -.30% (80 occasions up, 83 down). When SPY has been down for the past one and three days, the next three days average a gain of .22% (82 up, 51 down). If traders wait several days for a trend to assert itself and then jump on board, they are likely to start in the hole.
When we look internationally at the Europe, Australasia, and Far East (EAFE) stocks (EFA), when those are up on a one- and three-day basis, the next three days average a loss of -.27% (76 occasions up, 80 down). When EFA has been down over the last one and three days, the next three days have averaged a gain of .09% (74 up, 65 down).
Finally, when we examine emerging market stocks (EEM), we find that when they are up on a one- and three-day basis, the next three sessions average a loss of -.31% (86 up, 81 down). When EEM has been down over the last one and three days, the next three days have averaged a gain of .69% (79 up, 45 down).
Across the globe, short-term trend following has been hazardous for traders' wealth. Even longer-term traders need to take these reversal patterns into account, if only to size positions and set stops for expected heat.
Fading the Herd
Momentum and Reversal Effects