The (NEW) State of Short-Term Mean-Reversion: July, 2010
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.
*** CLICK TO ZOOM ***
I’ve changed up the format of the report, but we’re still using the same two simple strategies to serve as proxies for all short-term MR:
- The first, daily mean-reversion, assumes that we went long the S&P 500 at the close when the S&P 500 closed down for the day, and short at the close when it closed up.
- The second, RSI(2) stretch, assumes we took a larger long position the deeper RSI(2) closed towards 0, and a larger short position the deeper it closed towards 100. For example, RSI(2) of 0 = 100% long, 25 = 50% long, 50 = no position, 75 = 50% short, 100 = 100% short, etc.
I’d never suggest trading either strategy 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.
Both strategies weight long and short trades equally. As the graph of each strategy’s performance since 2000 makes clear, for most of the last decade, playing it “symmetrical” has been an effective strategy.
Reading the Report
The first table in the report shows results over various periods of time in terms of volatility-adjusted daily return. Vol-adjusted daily return is simply average daily return divided by the standard deviation of daily returns, and serves to normalize results regardless of market volatility.
From my own experience, I’d characterize results above 10% as being very good (and profitable). Negative results mean that particular strategy lost money over that timeframe. To put the numbers in some perspective, I’ve also included buying and holding the S&P 500 index.
The two graphs below that (click to zoom) plot 3 and 12-month vol-adjusted returns so that we can better see whether short-term MR is waxing or waning.
The State of Short-Term Mean-Reversion
Since I’ve taken up so much time already, I’ll keep my comments short.
As we’ve discussed ad infinitum, short-term MR has been weak for about a year now, but as both graphs show, we’re still within ranges that we’ve seen in the past. For the moment I’m expecting short-term MR to again be the play du jour.
I’ll have more detailed comments in next month’s health check.
Geek note: returns in this post have NOT been dividend-adjusted.
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Filed under: State of Short-term MR | 7 Comments