Minyan Mailbag: Context, Part Deux
Well, I'm not sure what to think now!
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I've received quite a few questions about the intraday reversal stat that I posted earlier, and my guess is others have similar questions, so here goes...
"In your last Mailbag, you said you expected more downside. How do you reconcile that with the bullish implications of your reversal study?" Minyan Pete
The reversal study is one input to my overall gauge of risk. With the current sentiment situation, as I see it the risk is greater to the downside than upside. I expect prices to decline further, but part of my reasoning is NOT because we had an intraday reversal yesterday.
"Would 2 reversals back-to-back make a difference?" Minyan JK
Not really. Since 2003, we've seen two consecutive reversals (one being at least 1%, the other .5% from previous close to that day's high) six times. Ten days later, the Dow was higher 4 of the 6 times, with a return of +1.6%. Over the past 80 years, the results were slightly positive going forward - still positive a majority of the time across all time frames, but overall a bit less than random.
"What if the market had just hit a new recent high, did that make it bearish?" Minyan Duke
There are an infinite number of inputs we could test to check for applicability to the current situation, and yours is one of them. Looking at recent activity, no it didn't make it bearish. Ten days later, the Dow was up 3 out of 4 times with a return of +2.9%. Long-term the results going forward were slightly more positive than random.
"Since stocks have tended to go up over time, i.e. have a drift factor in their dynamics, do you normalize your data when you say for example that 60% of the time the market was up 10 days later (in reference to one of your posts today)?" Minyan Bill
Yes, and no. Yes, I do account for that in many studies, but no I didn't for this particular one. It's important to take into account the larger market context when looking back more than a few years (particularly the 80 years that I cited) - your results could be good, but they may not have beaten a random return during the study period. I didn't normalize the results at all for the intraday reversals simply because I wanted to see if the market really did "almost always decline further" on an absolute basis.
"Do you really think what happened 80 years ago is applicable to today?" Minyan Steve
Good question, and it's one I always struggle with. We want to go back as far as possible to get as many occurrences as we can (a problem when just using recent history), but the further back we go, the more we have to accept the fact that market dynamics have changed. Program trading, the proliferation of quick-trigger hedge funds, decimalization, etc. all change the dynamics of today's market versus markets of 10, 20, 50 years ago. There's no right answer, we just have to acknowledge the weaknesses of what we're looking at and accept the uncertainties.
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