Wednesday, March 08, 2017

The Challenge of Changing Market Regimes

In the post on when technical analysis works and when it doesn't, I proposed that markets move in and out of periods of stability.  During stable periods, we have relative uniform participation in the market and those participants are doing relatively uniform things in terms of buying and selling.  A technical analysis indicator that "works" during such a stable period will tend to continue working as long as that uniformity continues.  Once we see a different level of participation (volume) in the market and/or once the distribution of buying and selling among participants shifts, then new patterns emerge.  The technical patterns that had been reliable no longer are such going forward.

This alternation of stability and change occurs at all time frames for markets.  It is a major reason why trading is so difficult, and why it is more difficult than many other performance domains.  The football field does not occasionally change its dimensions; nor do the rules of football shift part way into a game.  The equivalent of those things happens daily in financial markets.

The ability to rapidly detect and adapt to regime shifts is a characteristic we see among successful traders and money managers.  This is as much a cognitive set of skills as a set of personality strengths.

Above we see SPY going back to the start of 2015 (blue line).  The red line is a cycle measure derived from the proportion of stocks trading above various moving averages.  It acts as an overbought/oversold measure.  Note the change in the distribution of the cycle measure from early 2016 forward.  It was at that time that we saw a corrective period end and a bull market leg begin.  The market still cycles (we are in a corrective phase currently), but the dimensions of those cycles are greatly different in an uptrend than in a flat/corrective market.

A major challenge for daytraders is that markets will change regimes during the trading day, with greatest participation early and late in the day and different levels of buying and selling at those times.  This is also true for portfolio managers, many of whom develop fundamentally-based ideas that are meant to play out over periods of time in which markets are likely to change their patterns.  The trader who displays "good timing" is one that is sensitive to regime shifts.  If we think of technical indicators more as barometers than as crystal balls, they can be helpful in sensitizing us to the emergence of new regimes.

Further Reading:  Finding Good Trades