Evolving Markets and Dynamic Systems

I’ve been devoting a lot of time over the last year to the idea of systems capable of adapting to evolving markets rather than being coded with static rules. For example, our original MarketSci strategies are very static and require manual tinkering as markets change. By contrast, our new YK strategies have no hard-and-fast rules – rather, they are designed to “learn” how to trade from the market.

In this post, I want to look at a very clear example of the market evolving over the last 60 years or so: “daily follow-through”. What I mean by follow-through is 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?

That’s a simple enough question to answer, but here I want to show how the answer has been changing over the last 6 decades. The graph below shows a 5-year moving average of the next-day returns on the S&P 500 following an up day (red) and a down day (blue) from 1950 to 06/2008.

Geek notes: (1) returns have been normalized by subtracting the average return of all days in each observation period to remove the influence of bull vs bear markets, (2) averages are geometric.

For most of the last 60 or so years, the market has exhibited at least some degree of follow-through; up days tended to follow up days and vice-versa. This peaked in the first half of the 1970s when there was a +0.43% difference between next-day returns following up vs. down days.

However, since the mid-1970s, this difference has been slowly eroding, and since the new millennium, it has actually flipped to contrarian. Up days now tend to be followed by down days, and conversely, down days tend to be followed by up days. As of the end of June, the five year average difference in performance was about 0.16%.

Now, absent other factors, the difference as of this moment isn’t large enough to be tradable; however, it is large enough that traders might need to consider it as a part of their overall strategy.

But more importantly, it demonstrates that the fundamental characteristics of the markets are in constant flux. We must adapt to the mood of the markets and be ever open to changing our assumptions about “the way things work”.

Disclosure: I periodically hold short-term positions in mutual funds and ETFs that track the Nasdaq 100 and S&P 500 indices.

Comments

[ain't no fo...:]

Have you correlated the change to the increasing influence of hedge funds in the markets?

2008 Aug 12 10:41 PM