The State of Short-Term Mean-Reversion: July, 2009
This is the first in what will be a monthly health check of short-term mean-reversion in the US market.
Short-term mean-reversion (by “short-term”, think for example RSI(2)) is so important to what we swing-traders are doing right now because at this moment in history, it’s the most effective (directional) trade.
But here’s the kicker: around the turn of the century short-term MR radically evolved, and it’s only a matter of time before everything is turned on its head again (read more and more). This monthly report aims to foresee that next evolution.
There are infinite ways traders are playing short-term MR: RSI(2), stochastics, fast MAs, DV(2), etc. so we need a single gauge of short-term MR that can serve as a proxy for all. I think that proxy should be daily mean-reversion in the S&P 500, or put another way, the tendency of up days to be followed by down days, and vice-versa.
We’ve talked about daily MR ad infinitum. It’s not appropriate for actual trading (it’s too volatile, drawdown prone, and weak relative to trading frictions), but its evolution from being momentum-driven in the last century to MR-driven in this century, is a near perfect match with the evolution we see in all other very short-term indicators, because conceptually, this tendency for the market to retrace very recent gains is exactly why all of these short-term indicators work the way they do.
The report will consist of three charts, each showing the monthly results of trading a daily MR strategy, in terms of (a) average daily return, (b) return versus volatility, and (c) win percentage.
The proxy strategy will be: go long the S&P 500 at today’s close if the index closed down today and short if it closed up.
The first chart shows the strategy’s (frictionless) average daily return from 2004 by month. I’ve also included 1-year (red) and 5-year (blue) averages for perspective, and highlighted the most recent month in dark grey.
Daily MR appears to have become considerably stronger in early 2007, but that’s a little misleading, because a good bit of that bump is a result of increased volatility in the market (rather than an increase in the effectiveness of the strategy), so of all three charts, I think this one is the least useful.
The second chart attempts to compensate for that increase in market volatility by dividing the average daily return each month, by the standard deviation of daily returns (a simple risk-adjusted measure).
Here daily MR still tests stronger over the last year and a half, but not to the same degree it did when we just looked at pure return.
Finally, the third chart shows strategy results in terms of win percentage, and is trying to capture to what degree daily MR is binary and to what degree it’s a function of winning days being larger than losing ones. The former would benefit strategies like daily MR or unbounded DV(2), while the latter might benefit strategies that took advantage of “stretched” markets like extreme RSI(2).
So what is the current state of short-term mean-reversion?
Alive and well.
Across all three metrics 1-year averages (red) trounce 5-year averages (blue), July outperformed the averages for the two most important metrics (return vs volatility and win %), and no significant downtrend is afoot.
I sincerely hope that every report is as clear cut as this one, but when it isn’t (and one day it won’t be), I hope that we’re all a bit more prepared.
Filed under: State of Short-term MR | 27 Comments