We detect strength in the stock market and buy. We discover the weakness and sell. Both occasions you lose money. what is going on? In this article, we'll take a look at market behavior and how market patterns themselves create trading psychological challenges. The common assumption is that if we can maintain a good mindset, we will be able to identify market patterns and make money. This post will show that this is a gross simplification.
I examined daily data for the last three years, focusing on the SPY index and the percentage of stocks in the S&P 500 that trade above their 5- and 20-day moving averages. (Data from the excellent Barchart website). I divided the data set into quartiles and looked specifically at what happens after very strong periods (the top quartile) and very weak expansion (the bottom quartile).
When the percentage of stocks trading above their five-day moving averages was in the top quartile (about 74+%), the next five days in the SPY averaged a loss of 0.14%. Note that this was during a period when SPY was up about 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 (roughly 33% below), the next five-day SPY generated a gain of +.57%. In other words, going too aggressive beyond a five-day period will cause the trader to lose money regardless of his mindset. Buying stocks, after five days of weakness – when jumping into the market is most terrifying – was solidly profitable and more than doubled in average returns.
So let's now examine the average returns after 20 days of strength and weakness. When 20-day returns are the strongest (over 73% of stocks trade above their 20-day moving averages), the average loss over the next 20 days in SPY is about -31%. This is surprising, as the average 20-day gain during this period was +.79%. Conversely, when 20-day returns were at their weakest quarter (less than 37% of stocks trading above their 20-day moving averages), the next 20 days produced massive gains of +1.85%. Going too aggressively leads to traders systematically losing money; Fading weakness has delivered superior returns.
In short, traders lose money when they focus on trend and momentum. They expect both strong and weak returns to continue in the future. However, what actually happens on average is a reversal. Stocks behave in a cyclical manner. When markets show momentum and trend, it is generally because long-term cycles are dominant. The bullish or bearish phase of the long-term cycle overshadows any reversal trends in the short-term. (Note how this opens the door to predicting market movement as a function of the interaction of multiple cycles: a topic I hope to address soon.)
The market tends to disappoint traders' expectations. It is human nature to extrapolate the future from the past. This – regardless of the trader's psychological state – will lose money over time. Drawing trend lines and following them, going with breakouts, waiting for “price confirmation” to enter market moves: all of which, over time, lose money. It's not just our psychology that undermines our trading. It's our assumptions.
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