Sunday, March 16, 2014

Putting Markets in Historical Perspective

I just took a look at the most recent report from Quantifiable Edges, including a historical study that examined what happens when (as on Friday) SPY drops on positive NYSE breadth.  Interestingly, over the near term, winning periods outnumbered losing ones by about 2:1.  If you check out the Quant Edges blog, you'll see similar studies posted. 

That pattern makes sense because the breadth is showing strength underlying the stock market, even while the large caps--which dominate the indexes--may be seeing selling.  Still, any trader looking to make use of that information has to make a key assumption: that the near-term future will mirror the past.  In other words, whatever has driven forward price movement in the backtest will persist as drivers during the next market period.

I think of historical patterns as precisely that:  a script that markets should follow if they are driven by the same factors that influenced past price movement.  In addition to how markets *should* trade, however, there is also how markets *are* trading.  That is why measures like NYSE TICK and Market Delta are valuable from my perspective:  they tell us if buyers or sellers actually are dominating the market.  It is when how markets *are* trading lines up with how markets *should* trade that interesting trading ideas emerge.

And if markets don't follow their historical scripts?  That, too, is information.  It tells us that markets are responding more to current, idiosyncratic factors than historical ones.  In such a situation, I want to find out what those present drivers are and track their waxing and waning.  The historical query from Quant Edges suggests we could see a bounce in the first half of the coming week.  We know, however, that there are unsettling events in Russia/Ukraine and China that could trump those odds.  Teasing apart those present influences from the historical ones will be a key to successful trading this coming week.

Further Reading:  Historical Studies and Being Prepared