Why This Market Is So Difficult: The Long-Term Picture
Why This Market Is So Difficult: The Long-Term Picture
Brett N. Steenbarger, Ph.D.
Note: A version of this article appeared on the Trading Markets website 3/17/06.
Before I present some eye-opening findings, allow me to propose a thesis:
Every market has its personality, and that personality is defined by two traits: Volatility and Trendiness. A volatile market is one that moves a great deal from time period to time period. A trendy market is one that tends to move in the same direction from one period to the next. Over time, markets change their personalities, which is to say they change their volatility and trending. This is part of what makes markets so difficult to trade: just as traders adapt to one market personality, another is likely to take its place.
What we've seen in recent years in the S&P 500, however, is a personality change worthy of Jekyll and Hyde. I believe this accounts for the common perception among retail and professional traders alike that the recent period has been one of the most difficult on record to trade.
In fact, I can prove it.
For my investigation, I went back to January, 1934. I looked at two time periods in the Dow Jones Industrial Average: hourly (the first hour of the day) and daily and measured their volatility and trendiness. Both of these were measured as a 500 day moving average, which covers roughly two years of trading. Hourly volatility was measured as the absolute values of the price changes from the close of the previous day to the close of the first hour of the current day. I used first hour data only, since this is commonly the most volatile intraday period. Daily volatility also looked at the absolute value of price changes from the close of the prior day to the close of the current day.
To assess trendiness, I followed the methodology of my recent article. I examined the number of occasions in a moving 500 day period in which rising first hours (days) were preceded by rising last hours (days) or falling first hours (days) were preceded by falling last hours (days). Recall that, if we assume that the odds of a rise or decline are 50/50, we should average about 250 occasions out of 500 where a rise or decline continues into the next period.
First we'll start with volatility. Here is the chart for hourly volatility:
[pic]
Now here is the chart for daily volatility:
[pic]
As you can see, for all practical purposes they are identical. They show us three things: 1) current volatility has dropped considerably from the 2003 peak; 2) by historical standards today's volatility is below average, but not historically unusual; and 3) periods of low volatility can persist for considerable periods of time. Indeed, volatility could drop further and we still would not be at historic lows.
Now let's look at trendiness at an hourly level:
[pic]
This absolutely floored me when I saw it. Notice that we were above the 250 level consistently from 1934 to 1976. Since 1976, however, the trending quality of the first hour has gone steadily downhill, to the point where we're now well below 250 at historic lows. For the first time in market history, this suggests, we are now *more* likely to fall in the first hour if the last hour of the prior day is up and vice versa. This hourly pattern fits with the intraday studies on my research site.
How about trendiness on a daily basis?
[pic]
Once again, we see a very similar pattern. In the mid-1930s we saw some values below 250, but after that, up days were more likely to be followed by up days and down days by down days. This changed starting after 1976, and now we have been below 250 rather consistently. Instead of trending, markets are tending to reverse the direction of their prior period.
So let's put these findings together: We are seeing reduced volatility *and* we are seeing reduced trendiness. That means that traders are able to take less movement out of trades *and* they are less likely to see movement carry over from one period to the next. Is it any wonder that traders are experiencing such difficulty? We have never seen a market personality quite like this one, in which low volatility has also been accompanied by low trending.
But now the bad news. I've also performed historical studies of trendiness on a five-minute basis (reported on my research site). The proportion of trending occasions is nowhere near even the one-half level; it's more like one-third. That is because of the low volatility: a third of the time the market doesn't move at all (price stays constant) and another third of the time the market reverses. The short-term momentum trader is thus in the worst of all possible worlds, as low volatility produces a lack of movement and low trending produces a lack of follow-through on moves.
I believe traders--especially short-term traders of the stock indices--need to take these findings very seriously. To the extent that the loss of trending is created by increased arbitrage and program trading, there is no assurance that it will reverse. Moreover, we've seen that the loss of volatility in the market can also persist--and even get worse. To blindly hope that the market will "get better" is not a trading plan, much less the plan for a trading career.
The good news is that there are trading instruments with far higher levels of volatility and trendiness, and those include many individual stocks. (One look at this is on the Trader Performance page of my personal site). Note that this makes stockpicking and portfolio selection more important than ever. There aren't any universal laws in trading, but this one might come close: Make sure the personality of what you trade fits with how you trade.
Bio:
Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at and a blog of market analytics at traderfeed.. He is currently writing a book on the topics of trader development and the enhancement of trader performance due for publication this fall (Wiley).
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