I examined the last three years of daily data, focusing on the SPY and the percentage of stocks in the Standard and Poors 500 Index trading above their 5 and 20 day moving averages. (Data from the excellent Barchart site). I divided the data set into quartiles and specifically examined what happens following periods of very strong (top quartile) and very weak breadth (bottom quartile).
When the percentage of stocks trading above their five-day moving averages was in the top quartile (approximately 74+%), the next five days in SPY averaged a loss of -.14%. Note that this was during a period in which SPY rose by approximately 30% and the average daily gain was +.20%. When the percentage of stocks trading above their five-day moving averages was in the bottom quartile (approximately less than 33%), the next five days in SPY averaged a gain of +.57%. In other words, going with strength after a five-day period lost a trader money regardless of their mindset. Buying stocks,after five days of weakness--when it's scariest to be jumping into the market--was solidly profitable and more than doubled average returns.
Hmmm...
So now let's examine average returns after 20 days of strength and weakness. When 20-day returns have been strongest (over 73% of stocks trading above their 20-day moving averages), the next 20 days in SPY have averaged a loss of about -.31%. This is eye-opening, as the average 20-day gain during this period was +.79%. Conversely, when 20-day returns have been in their weakest quartile (fewer than 37% of stocks trading above their 20-day moving averages), the next 20 days have averaged a whopping gain of +1.85%. Going with strength systematically lost traders money; fading weakness achieved superior returns.
In short, traders lose money when they focus on trend and momentum. They are expecting strong and weak returns to continue into the future. What actually happens on average, however, is reversal. Stocks behave in a cyclical way. When markets *do* display momentum and trend, it is generally because longer-term cycles are dominant. The up or down phase of a longer-term cycle overwhelms any reversal tendencies in the short run. (Note how this opens the door to forecasting market movement as a function of the interaction of multiple cycles: a topic I hope to address soon).
The market tends to frustrate the expectations of traders. It is human nature to extrapolate the future from the past. This--regardless of a trader's psychology--will lose money over time. Drawing and following trendlines, going with breakouts, waiting for "price confirmation" to enter market moves: all, over time, lose money. It is not just our psychology that undermines our trading. It is our assumptions.
Further Reading:
The Secret to Overcoming Adversity
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