Monday, July 11, 2016

Quant Stuff: "How the Market Behaves at All-Time Highs"

S&P 500-2,140.76.

From Crossing Wall Street:
(This post originally appeared on August 12th, 2015.) 
Finance people tend to be numbers people. I’d certainly include myself in that group. You can mention any financial topic and there are dozens of studies, charts and regressions on it. Name it and the numbers have been crunched. 
This obscures an important point. All these numbers do is explain a few basic truths about the market. What can be told with numbers only reinforces what can be said with words, and usually only a few words. 
The important truths about the market aren’t many and they aren’t complicated. Investors need to understand them. On Monday, for example, I highlighted the recent behavior of Royal Caribbean(RCL). The stock dove in October due to fears of Ebola. It’s recovered and gone on to soar to new heights. 
With our RCL example, the important truth is that stocks oscillate between large, quick downdrafts and long, slow up trends. The downs are fast and dramatic, the recoveries are slow and boring. Yet, it’s the boring part that makes all the difference. People spend too much time worrying about the painful declines and not enough time on riding out the long rallies. 
Earlier this year, I looked at all the daily closes for the S&P 500 going back to the 1930s. I found that all the days where the market went up or down by more than 1.17% canceled each other out. The entire gain came from the low volume days. You hear a lot about tail risk, but the important part of the distribution is the tall heads.(Incidentally, the market’s returns aren’t merely fat-tailed, they’re tall-headed as well. That’s “leptokurtic” if you’re looking to impress people.) 
Most of the market’s big one-day gains have come right after big one-day losses. I asked Ryan Detrick, a must-follow on Twitter, to look at how the S&P 500 has behaved when it’s at a new all-time high. As I suspected, the market is far calmer than it normally is, and the return has been better as well. 
Since 1950, there have been 1,026 trading days following a new high. (Technically, we could say the study goes back to 1929 because it took until 1954 for the index to make a new high.) That’s about 6.2% of the time, or one new high in every 16.1 days. 
Of those 1,026 new highs, the market rose the following day nearly 56% of the time. That compares with 53% for all days. 
To me the arresting fact is the standard deviation. For all market days, the standard deviation is 0.965%. But when the market’s at a new high, it’s only 0.611%. That’s more than 36% less volatility. 
In the last 60 years, the S&P 500 has risen by more than 2% following a new high just three times. The normal market sees 2% up days more than four times more frequently. It’s probably more appropriate to say that volatility rises when the market is off its high than to say that volatility is lower at the top....MORE