The State of Short-Term Mean-Reversion: January, 2010

04Feb10

This is our monthly health check of short-term mean-reversion in the US market.

Why a health check? Because short-term mean-reversion (by “short-term”, think for ex. RSI(2) or DV(2)) is so important to what we index swing-traders are doing right now because at this moment in history, it’s the most effective directional trade.

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See the July and August reports to understand how this report is calculated. In a nutshell, we’re using daily mean-reversion (the likelihood that down days follow up days, and vice-versa) and RSI(2) as simple proxies for all short-term strategies. I’d never recommend anyone trade either as I’ve defined them, but they make a good proxy because 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 State of Short-term Mean-Reversion

Short-term MR was moderately strong in January, with all key metrics above their 1-year averages. It’s way too early to call it “healthy”, but it’s a step in that direction.

I continue to work off the thesis that the breakdown in short-term MR in the second half of 2009 was a temporary aberration caused by the particularly strong bull market. Seeing the market lose some steam in January and make a return to short-term mean-reversion helps to strengthen that thesis.

Dear Sherlock Holmes, this Report is About Short-Term MR

One last note…

Without fail, every time I release this monthly report some wise man blesses me with the wisdom that I’ve got it all wrong: short-term MR is very strong in the direction of the trend.

Yes, thank you Sherlock Holmes.

As I hope I’ve made clear on this blog (ex. the State of the Market report) I think it’s uber-important that swing traders are taking all three timeframes into consideration: the short, intermediate, and long-term.

But this report isn’t about that…this report is about short-term mean-reversion.

In “normal” times short-term indicators (ex. RSI(2)) have performed regardless of the broader trend. The long side has performed better in bull markets and the short side in bears, but overall, a perfectly symmetrical indicator has done well. The breakdown we saw in short-term MR in the second half of 2009 was something we haven’t seen often in the last decade, hence the reason we created this report.

If and when the market changes from being mean-reversion driven back to being follow-through driven (as it was prior to the late 1990’s) ALL of the short-term indicators we use to trade will change with it…that’s something pretty important.

Happy Trading,
ms

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