Why last week’s decline is bullish
You probably didn’t know that the decline of the S&P 500 Index
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the last two days was the fifth largest decline we’ve had since May of 1996.
The market’s decline on Thursday and Friday amounted to a loss of about
2.5%. Since May, 1996, we’ve had 147 two-day periods that have dropped
more than 2.5%.
And yet, the past two sessions have been the fifth weakest during that time.
What gives?
To answer this little dilemma, I’ll have to ask you to think like a
psychologist. Psychologists know that what people respond to are not
events themselves, but interpretations of those events. An unprepared
student reacts to a test as a threat; a good student views it as a
challenge. Same test: two different responses.
Maybe the same thing is true for market movements as well. What traders
respond to are not movements themselves, but the perception of those movements.
Here’s a simple example from everyday life. Suppose the outdoor
temperature is 45 degrees. Can we predict people’s responses to the
temperature?
Well, if it’s 45 degrees during the middle of January in my former Syracuse
home, I confidently predict people will be outdoors enjoying the respite from
the snow and cold, smiles firmly planted on their faces. If it’s 45
degrees during an August afternoon in Maui, I equally confidently predict you’ll
have some glum faces and residents staying indoors to avoid the chill.
Same temperature: different responses.
SPY was down about 2.5% over the past two days, but suppose we measure price
change in relative terms? Suppose we measure price change as a multiple of
the median two-day change over the past 60 days?
In this low volatility environment, the median daily price change of the past
60 days has been .47%. For all of 2006, the market’s median two-day change
has been .57%. Compare that to the 1996-2006 median of 1.05% and the 2002
median of 1.53%. A drop of 2.5% over two days was only about 60% above
average in 2002, but more than five times the present average (5.3 to be
precise).
And maybe traders don’t react to the absolute magnitude of price changes,
just as they don’t react to the absolute reading shown on a thermometer.
Forty-five degrees in the dead of winter elicits a different response than it
does in mid-summer. A 2.5% drop in a high volatility market may be a much
more routine event–and elicit a far more moderate response–than a 2.5% drop in
a low volatility market.
If we look at what happens to the market two days after a two-day decline of
2.5% or more, we learn that the average change is .32%, but the median change is
only .14%–similar to average for the sample (78 up, 69 down). If we look
at what happens to the market after a two-day decline that is more than 5.3
times the average two-day price change, we have a sample of only four. All
four were up two days later by an average of 2.63% and a median 2.48%. In
relative terms, the market two-days later was up by an average multiple of 2.47
times its 60-day average change, which in the current market would amount to
1.18%.
My research overall suggests that market outcomes are more skewed–and
potential trading edges larger–when we treat price changes in relative rather
than absolute terms. TradingMarkets has found that viewing other
indicators–such as the VIX–in a relative light is far superior to dealing with
absolute
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other market indicators that show different averages and standard deviations
from one market period to the next.
Brett N. Steenbarger, Ph.D. is Associate Clinical
Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical
University in Syracuse, NY and author of The
Psychology of Trading (Wiley, 2003). As Director of Trader Development
for Kingstree Trading, LLC in Chicago, he has mentored numerous professional
traders and coordinated a training program for traders. An active trader of the
stock indexes, Brett utilizes statistically-based pattern recognition for
intraday trading. Brett does not offer commercial services to traders, but
maintains an archive of articles and a trading blog at www.brettsteenbarger.com
and a blog of market analytics at www.traderfeed.blogspot.com.
His book, Enhancing Trader Development, is due for publication this fall
(Wiley).