Exploiting the edge from historical market patterns

Aftermy recent post on bullish market sentiment, a reader expressed surprise that we were seeing such protracted optimism. After all, werent housing prices falling? Isnt the war going poorly? Arent we reacting to geopolitical problems in North Korea, Iran, and the Middle East more widely?

My response was that, perhaps, sentiment is simply a function of price. We havent seen a 10% correction in the Dow since the 2003 start of the bull market. Perhaps thats why sentiment has remained elevated.Its not just that bullish sentiment leads people to put their money on stocks; rising stocks also might generate bullish sentiment.

Such a conclusion would fit withthe interesting researchnoted on the excellent CXO Advisory blog, which found that margin debt actually slightly lags stock index price: people borrow money for investment when they see rising prices.

Above we see a chart of weekly data from 2003-present. The red line is a detrended composite measure of sentiment taken from the three surveys from my prior research. The blue line represents weekly 52-week new highs minus new lows in the NYSE, adjusted as a percentage for the number of issues traded. Note that there is a strong correlation between new highs/lows and sentiment. Indeed, from July, 1987 to 2006 (N = 980 weekly periods), the correlation between new highs/lows and sentiment has been .54.When we have many stocks making new highs, sentiment tends to be more bullish; when we have many stocks making annual new lows, sentiment tends to be less bullish.

Viewed another way, we can say that the new highs/lows account for almost 30% of the variance in investor sentiment. That still leaves a chunk of variance unexplained–and room for sentiment to diverge from the new highs/lows.

Might there be trading patterns in such divergence?

When bullish sentiment across the three surveys runs 10% or more above average (N = 124), the next 20 weeks in the Dow Jones Industrials average a gain of 1.46% (70 up, 54 down). That is weaker than the average 20-week gain of 3.67% (682 up, 298 down) for the entire sample.Very bullish sentiment leads to inferior returns in the intermediate term.

But wait! Lets divide the bullish sentiment periods in half based upon the new highs/lows. When new highs are strong *and* we have high bullish sentiment, the next 20 weeks in the Dow average a gain of .28% (28 up, 36 down). When new highs are not strong and there is bullish sentiment, the next 20 weeks in the Dow average a gain of 2.63% (42 up, 22 down).

What that says is that markets yield subnormal returns when lots of stocks are making new highs and investors are very bullish. When investors are bullish in the absence of great strength in new highs, that bullishness is associated with much more normal returns going forward.

How about when sentiment is bearish? When bullish sentiment has been 10% or more below average (N = 114), the next 20 weeks in the Dow average a gain of 7.30% (94 up, 20 down), much stronger than the average 20-week Dow gain.That tells us that very bearish sentiment leads to superior returns in the intermediate term.

When we have weak bullish sentiment *and* a high level of stocks making new lows (N = 57), the next 20 weeks in the Dow average a gain of 9.1% (50 up, 7 down). Thats stronger than the performance when we have weak bullish sentiment and a low level of stocks making new lows (5.49%; 44 up, 10 down).

In short, sentiment is highly but not perfectly correlated with price and market strength.Its when sentiment is highly bearishandlots of stocks are making new lows that returns are most favorable for investors.

Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab). I teach brief therapy as Teaching Professor at SUNY Upstate in Syracuse, with a particular emphasis of solution-focused therapies for the mentally well. Co-editor of The Art and Science of Brief Psychotherapies (American Psychiatric Press, 2018). I dont offer coaching for individual traders, but welcome questions and comments at steenbab at aol dot com.

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