Friday, October 27, 2006

When Markets Don't Correct, Are We Due For A Correction?

The most recent post on evidence-based trading emphasized the importance of our knowing what we know.

This was illustrated for me quite recently when I read that we were due for a meaningful correction because we hadn't had one for a while.

Let's see if that reasoning is valid.

It turns out that we haven't seen a daily 1% or greater decline in the cash S&P 500 Index ($SPX) in over 60 trading sessions. Since 1990 (N = 4183 trading days), this has only occurred on 177 occasions. When we look at what happens 60 trading days later, it turns out that the S&P 500 Index is up by an average of 4.61% (153 up, 24 down), quite a bullish edge compared to the average 60-day change of 2.21% (2845 up, 1338 down). Over essentially every time frame leading up to 60 days, moreover, we see above average returns following from periods in which we haven't had a 1% daily correction.

In short, the absence of a drop does not make a fall more likely. Indeed, it has led to superior returns over the intermediate term.

Why is this? The majority of periods when we haven't had a large drop are periods in which we haven't had large moves of *any* kind. These have been low volatility periods in the market, from 1993-1995. Recall from the recent post that low volatility periods have actually shown superior returns over the intermediate term.

Are we overdue for a drop? Yes. We don't typically have runs of no 1% declines for months at a time. Does that mean the market is headed lower? Not at all. Only six of the 177 periods in which we have not had a 1% drop led to a decline of 2% or more in the following 60 trading sessions.

It helps to know what we know: that's the appeal of an evidence-based approach. Tomorrow we'll explore the limitations of the approach.