A Slinky (Short-term Reversion) Effect?
Posted in Technical Trading, Volatility Effects
July 1, 2010
Do investors/traders tend to overdo it during buying and selling frenzies, coming to their senses shortly thereafter? In other words, does the broad U.S. stock market tend to revert after short-term moves up or down? To check, we relate sequential past and future return intervals of 1, 2, 3, 5, 10, 15 and 21 trading days. To avoid overlap of observations (and ensure a trader could exploit all of them), we sample at frequencies matching these seven intervals for respective return calculations. For example, for a 5-day return interval, we sample every fifth trading day. Using daily closes of the S&P 500 Index over the period January 1990 through June 2010, we find that:
The following chart shows return autocorrelations, rough indications of the degree of short-term reversion, for the specified seven S&P 500 Index measurement intervals over the entire sample period:
- The return on the last trading day to the return on the next trading day (1:1).
- The return over the last two trading days to the return over the next two trading days (2:2).
- The return over the last three trading days to the return over the next three trading days (3:3).
- The return over the last five trading days to the return over the next five trading days (5:5).
- The return over the last 10 trading days to the return over the next 10 trading days (10:10).
- The return over the last 15 trading days to the return over the next 15 trading days (15:15).
- The return over the last 21 trading days to the return over the next 21 trading days (21:21).
Sample sizes range from 5,164 for 1:1 to 244 for 21:21. Results suggest that the U.S. stock market may exhibit a slight degree of systematic short-term reversion (sequences 1:1 through 5:5).
To investigate non-linearity in past-future return relationships, we look at average future returns by quintile of past returns.
The next chart shows average S&P 500 Index returns by quintile of past index returns. For example, the 5:5 series shows the average future 5-day return by quintile of past 5-day returns. The table below the chart provides the raw data. Again results suggest some degree of reversion for short measurement intervals (sequences 1:1 through 5:5), but the progressions across quintiles are imperfect.
The 5:5 reversion after the lowest past returns is perhaps the most attractive from a trading perspective, but the standard deviation of 5-day future returns associated with the 0.55% average gain is 3.84%, so trading this result is risky.
Note that testing all the combinations above introduces a degree of data snooping bias into results, so the best outcome may be overstated.
In summary, evidence from simple tests suggest that the U.S. stock market exhibits a slight degree of systematic reversion over short intervals (one to five days), but the effect is small compared to associated return variability and therefore risky to trade.
