I’m going to write about a pretty cranium-intensive subject this week, so to keep us all sane, I’m breaking it down into multiple parts. This first post will define the topic:
why is short-term (daily) stock market mean-reversion becoming stronger?
Recall a long ago post about daily follow-through. By “follow-through” I mean if the market is up today, how likely is it to be up tomorrow, and if it is down today, how likely is it to be down tomorrow?
In that post, I showed a graph like the following:
The graph shows a 6-year moving average of next-day returns on the S&P 500 following an up day (blue) or down day (red) from 1950. I “de-trended” the returns to remove the influence of bull/bear markets and just isolate daily follow-through.
For most of the last roughly 60 years, the market exhibited at least some degree of follow-through; up days tended to follow up days and vice-versa. However, since the mid-1970’s, this difference has been eroding, and in the new millennium, it actually flipped to contrarian. Up days now tend to be followed by down days and vice-versa.
Understanding and respecting this evolution in the market is key to trading short-term swing strategies like RSI(2) or adaptive daily follow-through.
This Week’s Series
Notice that over the last couple of years the tendency to reverse day-to-day has been accelerating. This is a huge shift in the markets coming on very quickly and is a big reason why short-term swing trading is becoming egregiously profitable (see my last couple of monthly results for example…December and January).
The topic of my upcoming posts will be understanding why. Not why did daily follow-through flip contrarian (because I don’t think that there is a way to know that), but rather, why this tendency is accelerating at warp speed right now.
Brush off your thinking caps…more to follow.
Happy Trading,
ms
