When Trading Advantages Die: Bank Leader/Laggard Strategy
I usually don’t like to talk about strategies that don’t work, but this one was interesting (and I think proves an important point), so here goes…
I was inspired by the Quantifiable Edge’s post Bank Action and the Market to look at how the market has performed historically the day following relative strength/ weakness in banking stocks (represented by the index BKX).
Below are results from early 1993 (when BKX launched) through the end of 1999:
[logarithmically-scaled]
The red line represents going long the S&P 500 tomorrow (from today’s close) if the bank index outperformed the S&P 500 today and the blue line if it underperformed. This is a proof of concept, so these results are frictionless (i.e. do not account for transaction costs or slippage).
That is an extremely consistent result. Remember, this isn’t some long-term strategy that might “appear” to be working solely as a result of market conditions at the moment. This is a very short-term strategy changing positions on average once every 2.0 days.
While I don’t think this observation was ready for prime time all by itself, I would have certainly used the general concept as part of some broader strategy.
But look at what has happened to the strategy in our current decade:
[logarithmically-scaled]
Ouch. Zero predictiveness.
Lessons learned?
Most of these we’ve talked about before. The markets are evolving. Trading strategies should either be adaptive, or we should at least be very sensitive to moving on to new strategies as current ones wane.
And something that I don’t know that I’ve specifically said (but I hope I’ve shown through this blog), we should constantly be in search of new trading advantages as the market offers them. They’ve always been there and (I believe) they’ll always be there…we just have to find em’.
Happy Trading,
ms
P.S. this is NOT a critique of Quantifiable Edge’s post. QE is looking at this BKX relationship at extremes, while I’m looking at it as much more of an everyday observation. If you enjoy the work we do here at MarketSci, then you’ll enjoy QE as well, so add em’ to your reader!
P.S.S. was there some change in the methodology used to calculate the BKX that led to the breakdown of this strategy? I dunno…any thoughts?
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Filed under: Evolving Markets, Stock Market Sectors, Trading Strategies | 4 Comments
Hi Michael,
How about scaling the performance of each by its recent vol before subtracting one from the other, rather than just a simple subtraction? Especially in light of how banking stocks have been so volatile these days.
On another note, perhaps this could be related to the daily follow through? For example, if BKX is generally more volatile (I’m assuming so here), when S&P is up, BKX should outperform, and we long the S&P the next day. When S&P is down, BKX should underperform, and we short the S&P the next day. Which is basically the daily follow through strategy, which also broke down after 2000 or so. Of course this is based on the hypothesis (I could be wrong) that the BKX is more volatile, and the correlation between BKX and S&P is pretty high.
RE to Lee’s daily follow-through analogy: very, very interesting idea sir. Will run some numbers and report back. Thanks for the thoughts. michael
Michael you have clearly disproved your version of the strategy.
Would be nice though if you could also chart Quantifiable Edge’s exact strategy, so we could see the performance of that over time.
RE to Paul: good idea, but QE is only looking at rare events (9 instances since 1992) so it would be a pretty flat boring graph =)
michael