Trade Stock Market Streak Reversals?

Extended stock market index winning and losing streaks elicit speculation in the financial media about pending reversals. Does evidence support the what-goes-up-must-come-down view that likelihood of reversal grows with streak duration? To check, we examine the recent behaviors of the S&P 500 Index and NASDAQ Composite Index during the one, two and five trading days after winning and losing streaks of at least three days. Using daily closes for the S&P 500 Index and the NASDAQ Composite Index for January 2004 through (most of) June 2011 (1,881 trading days), we find that:

Assumptions for testing are:

• Use close-to-close returns.
• Perform future return calculations based on index closes coincident with streak tabulations. In other words, a trader would have to determine streak status just before the close so that an associated trade takes place at the same close.
• Ignore overlap of streaks. For example, the first three days of all four-day streaks are included among three-day streaks, implying a trading strategy that scales into bets on streaks as they extend.
• Ignore trading friction (at least in detail).

The following pair of tables provides the number of occurrences, the average returns over the next one, two and five trading days and the standard deviations of these returns for streaks in the S&P 500 Index over the entire sample period. The first (second) table is for winning (losing) streaks. The one occurrence each of “7 Down” and “8 Down” of course derive from the same losing streak in October 2008.

Results are mixed across streak lengths and return horizons, making selection of specific trading rules problematic. Average returns are mostly small compared to standard deviations and to reasonable trading friction.

For visualization of return variabilities, we construct a chart for next-day returns.

The following chart shows average S&P 500 Index next-day returns after streaks occurring at least five times during the sample period, with one standard deviation variability ranges. While there are more reversals than continuations, any tendencies are generally small compared to variabilities.

Is behavior of the NASDAQ Composite Index after streaks similar?

The next pair of tables provides the number of occurrences, the average returns over the next one, two and five trading days and the standard deviations of these returns for streaks in the NASDAQ Composite Index over the entire sample period. The first (second) table is for winning (losing) streaks. The one occurrence each of “9 Up”, “10 Up”, “11 Up” and “12 Up” of course derive from the same winning streak in July 2009.

Results are again mixed across streak lengths and return horizons, making selection of specific trading rules problematic. Average returns are mostly small compared to standard deviations and to reasonable trading frictions.

The visualization below facilitates a consistency check across indexes.

The final chart compares the average next-day returns after various streaks with at least five occurrences in the S&P 500 Index and the NASDAQ Composite Index over the entire sample period. While reversal is more common than continuation, inconsistencies undermine belief in reliability of market reaction to streaks. Magnitudes are generally small compared to reasonable trading frictions.

In summary, evidence from simple tests does not support a belief that U.S. equity markets react reliably and exploitably after winning and losing streaks.

Cautions regarding findings include:

• Sample sizes are very small for long streaks, limiting confidence in returns and variabilities (and offering only rare trades).
• To the extent that return distributions are wild (plausibly more so around streaks), the average and standard deviation lose power as predictors.

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