Thursday, July 06, 2006

How the Market Confounds Human Nature: Time as a Market Indicator

Normally, we look for the occurrence of an event to signal a possible directional edge in the marketplace. In this analysis and the ones that will follow, we're actually looking at the absence of an occurrence as our market signal. Specifically, we'll take a look at how many days pass in the market before we see the S&P 500 (SPY) make a five-day price high. If many days pass without a five-day price high, we know we've been in a downtrend. If zero days pass without a five-day high, that means that the current trading session includes a five-day high.

Since March, 2003 (N = 833), we've had 77 days in which eight or more days have lapsed before making a five-day high. (The largest number of days without a five-day high during this period was 15, achieved during May, 2004 and March, 2005). Two days after the string of eight or more days without a high, SPY was up by an average of .39% (51 up, 26 down). That is much stronger than the average two-day gain of .07% (397 up, 359 down) for the remainder of the sample.

When the market has actually made a five-day high during the current trading session (N = 298), the next two days in SPY have averaged a gain of only .03% (156 up, 142 down). Streaks without a five-day high have thus been bullish in the short run, while the achievement of a five-day high has led to subnormal returns in the near term.

This is a good example of how the market runs contrary to human nature. After many days without price highs, traders tend to become bearish (as shown by sentiment measures). Once we achieve price highs, there is a tendency to become bullish. This overweighting of recent market information keeps players on the wrong side of short-term market cycles.