Where Are Edges To Be Found In The Current Stock Market?

I decided to take a stroll through my database and update views on where opportunity in the stock market has been residing since 2016.  That provides a lookback period long enough to detect meaningful patterns and recent enough to be relevant to current market conditions.  Here a few observations:

*  Sentiment matters:  When the equity put/call ratio has been in its highest quartile, the next ten day return in SPY has been +.96%.  That is almost four times the return when the ratio has been in its lowest quartile, +.25%.

*  Overbought/Oversold matters:  Let’s consider the percentage of stocks in the Standard and Poor’s 500 Index that have been above their 200 day moving average.  When that percentage has been in its lowest quartile, the next ten days in SPY have averaged a gain of +1.32%.  When the percentage has been in its highest quartile, the next ten days in SPY have averaged a loss of -.04%. (Data from the Index Indicators site).

*  Volatility matters:  When VIX has been in its lowest quartile, the next ten days in SPY have averaged a gain of +.69%.  When VIX has been in its highest quartile, the next ten days in SPY have averaged a gain of +1.02%.  When VIX has been in its middle two quartiles, the next ten days in SPY have averaged a gain of +.39%.

*  Context matters:  When the percentage of stocks above their five-day moving averages is low and the percentage above their 100-day averages is also low, the next ten days in SPY average a gain of 1.00%.  When the percentage of stocks above their five-day moving averages is low and the percentage above their 100-day averages is high, the next ten days in SPY average a gain of +.38%.

Now these are observations only; they no doubt overlap to some degree and I don’t pretend that, by themselves, they provide systematic trading ideas.  What is needed is some framework for accounting for these observations.  My straightforward framework is as follows:  the market has been largely trending higher (note how rarely we see negative average returns) and, within that trend, there have been meaningful cycles of 10-20 day duration that capture extremes of volatility, sentiment, and directional movement.

What this means is that traders with a habitually bearish bias have tended to underperform the opportunity set, and traders with a short-term time horizon (holding periods of intraday or swing periods) have also underperformed the opportunity set.  My sense is that a great number of market participants are overleveraged:  they have small account sizes relative to the returns they want/need to generate.  This leads them to take good-sized positions relative to the amount they can afford to lose, which inevitably leads them to manage their positions on shorter and less optimal time frames.  In actual practice, many traders simply don’t have the ability to take heat on holding periods of even 10-20 days, even though they may pride themselves on trading “macro” ideas.

My experience is also that traders are very keen to look for trends and trade directional momentum and lack the tools and frameworks to think about cycles and directional reversals.

In short, there do seem to be edges in the marketplace, but they’re not found by doing what the crowd is doing.  The key is not playing the game better, but figuring out the right game to be playing.

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