Friday, August 28, 2020

Actively Trading Momentum and Value In The Stock Market

This post will begin a short series on finding edges in the broad stock market related to momentum (directional persistence) and value (directional reversal).  A good place to start would be to review the recent post on how to trade a trending market.  Notice how the signal described in that post captured the most recent upside opportunity quite well.  Not all movement in the market is meaningful and it's easy to get so caught up in short-term ups and downs that we end up trading randomness.  If we can backtest patterns of momentum and value, we can begin to ground our trading is what is meaningful.

So let's begin simply.  We're interested in the percentage of stocks in the SPX universe that close each day above their respective five-day moving averages.  (Data can be found via the Index Indicators site).  That provides an indication of what I call breadth strength:  the degree to which there is broad strength or weakness in the market.

My database goes back to August of 2014, so let's see what happens in the market after five days of broad strength and weakness.  To accomplish that, I first divide the dataset into quartiles and examine average forward returns.  When we have seen the broadest strength in the market (top quartile of readings above five-day moving averages), the next twenty days in the market have averaged a gain of +1.31%.  When we have seen the weakest readings on our indicator, the market has averaged a 20-day gain of +.97%.  All other occasions in the market have averaged a 20-day return of only +.48%.  

In other words, we have achieved superior returns by buying the market when we've had unusually strong breadth and when we've had unusually weak breadth.  The unusually strong breadth has provided upside momentum; the unusually weak breadth has provided value.  During the overall upward market from 2014 to present, that has been a way of capturing a good chunk of returns in the market trend, as the recent post observed.  This simple indicator has done a pretty good job of tracking the psychology of the market.

Are there ways of improving on this indicator and refining our ability to trade value and momentum?  That is what we'll explore in the next post.

Using Breadth, Strength, and Momentum to Capture Market Cycles