Friday, July 07, 2006

Market Returns as Cycles Age: More on Time as an Indicator

In the last post, we saw how time can serve as a market indicator that measures how long it takes an expectable event to occur. The longer we had gone without seeing a five-day price high, the more bullish were the near term returns. In a Trading Markets article due out today, I also found this dynamic to hold for the number of 20-day lows exceeding 20-day highs. The longer it takes for us to get a reading in which 20 day highs exceed 20-day lows, the more bullish the short-term outcomes. (Note: 20 day new highs and lows are reported daily in the Trading Psychology Weblog).

But does this dynamic work the other way as well? If we see a long time pass before we see 20-day new lows exceed new highs, does that have bearish implications?

It appears so. Since 2004 (N = 609), we've had 84 daily occasions in which there have been 15 or more days passing before we've seen 20 day lows exceed new highs. Five days later, the S&P 500 Index (SPY) has been down by an average -.22% (39 up, 45 down). That is much weaker than the average five-day gain of .16% (296 up, 229 down) for the remainder of the sample.

Once again, we see that the market confounds human nature. Returns are subnormal when we've had a run of market strength (new highs outnumbering new lows) and--as the Trading Markets article shows--returns are superior when we've had a run of market weakness (new lows outnumbering new highs).

What this indicator is tapping, I believe, is cyclical behavior in the markets. By measuring the time that elapses before bullish or bearish market events occur, we are really assessing the aging of market cycles. It is not surprising from this vantage point that, as cycles age, countertrend returns become superior. It will be interesting to look at this phenomenon on longer time frames.