Tuesday, December 20, 2005

After a Flat Day: Context Matters

Tuesday was a flat day in the S&P 500. I looked at all days since January, 2003 (N = 746) and found 96 days where the market was neither up nor down more than .10% on the day. Two days following the flat day, SPY averaged a gain of .12% (56 up, 40 down). This compares with a two-day average gain of .09% for the sample overall. Clearly there is no meaningful edge associated with a flat day.

When, however, we look at the *context* in which the flat day occurs, a pattern emerges. Based on a median split of the data, I looked at how the market had behaved during the two days prior to the flat day. When the prior days were weaker (N = 48), the next two days in SPY averaged a gain of .32% (31 up, 17 down). When the two prior days were stronger (N = 48), the next two days in SPY averaged a loss of -.07% (25 up, 23 down).

In other words, a flat day after a decline (such as we had Tuesday) appears to have a more favorable two-day forecast than a flat day following a rise. The lesson here is that context matters: all short-term patterns are embedded in longer-term ones that may be important to the edge going forward.