Is There Method in This Market's Madness?

I've been working on a theory for some time. The Banker came out to move someone north and mentioned something during the move. He mentioned that after 8 straight days up, the Dow has to move lower. He felt that was a no brainer, and exited some trades.

That kind of spurred some thinking of my own. Should the markets have moved lower after so many days up? If so, or if not, then what's the basis behind this thinking?

Hmmm..... Are markets random or is there method in the chaos?

Let's take a look at one of the simplest markets we can find: The equities markets. First, let's take a look at the S&P 500 (SPY) since 1950 on a line chart:

You've probably seen this chart, or something similar, before. There is 14,360 lines of data that make up this chart. This is the U.S. equity market all wrapped up into one. This is how we've performed since 1950.

To call this chart random would be, I think, naive. After all, the chart clearly goes up in the long run, save for the recession of 2001. But, that's the long run. Let me query something: What percentage of days are up days? Out of 14,360 lines of data, what percentage of days are higher than the day before? Come up with a number, then read on.

In the long run, I believe that analysis does make a difference. But, in the short run, meaning you wake up in the morning and guess up or down without knowing anything about the market or what is going to move it, you actually have a 52% chance of it going up. That's right. After 14,360 days since 1950, the chance of today being an up day is 52%. The chance of it being an unchanged day is 1.5%. And 46.5% days are down. That's remarkable.

Okay, but is there a statistic that is being ignored: What is the median percentage of moves upward vs. downward: 1.15%/1.09%. That means that if it is going to be an up day vs. a down day, the move is likely to be no more than 0.06% higher. That's all.

But, what if you were one of those that just didn't like the idea of an aggregate that took in every single day of activity, and wanted to single out a bull market, just like the one we are in right now? Clearly the number of days that go up is going to be higher in a bull market, and considering the recent activity, this market should be impressive. In fact, the "impressive" number is a mere 0.025% higher with up days. Yup. The number of days that are up vs. the number of days that are down is still 52% vs. 46.5% (with 1.5% being hunch).

This calls into question whether or not analysis is worth a damn. In fact, on a short-term basis, it is not unless you are playing the statistics. See, if we've had a series of down days in a bull market, then yes, your analysis is worth a damn. Eventually we will see a move back up. That's a statistic.... And statistics don't lie. The old axiom: Buy low, sell high is far more important that you would think. On a long-term basis, your outlook does mean something. In the long run, the market is going to move higher. That's also a statistic.

So, statistically speaking, The Banker is on to something with his thinking that the market is "overbought". Yes, it was prudent, from a statistical standpoint that he exit his trades. But, if you wake up tomorrow and just pull a trade out of your hat, then you're just as likely to be right. On a short-term basis, the markets are in fact, random.

For those wondering, since this tends to be a currency column, the EUR is sitting at about 52% up vs. down as well vs. the USD. I think there are two things working on that statistic. First, most people are more likely to feel comfortable buying than selling. Second, we've seen a lot more bull markets than bear in the EUR vs. USD.

Comments

[Sonia Mirza:]

interesting.

Although Re: "After 14,360 days since 1950, the chance of today being an up day is 52%. The chance of it being an unchanged day is 1.5%. And 46.5% days are down. That's remarkable."

Round it, and you're basically saying there's a 50% chance the market will go up today - not particularly remarkable.

You do redeem yourself with the magnitude (0.06% higher, if it is indeed an up day) - which then calls into question whether chasing the .06% will result in $ or are you paying more to chase that .06% return ie is it worth it?

Glad that you do present more than 1 side, tho

2007 May 03 10:28 PM