Daily Commentary - Posted on Saturday, October 30, 2010, 10:58 PM GMT +1

5 Comments


Oct Saturday 30

Low Volatility and Bullish Optimism

Although US major market indices were not able to put in another multi-month high on close of Friday, October 29, the last trading week of October was at least good enough for 2 other multi-month high /lows:

With 2.96%, the SPY‘s annualized 5-day (1 week) realized volatility posted its lowest reading since March 15, 2010 (since 1990, there were only 77 sessions where the SPY‘s annualized 5-day realized volatility closed at an even lower level), and the American Association of Individual Investors (AAII) sentiment survey rose to 51.23% bulls (the highest level of optimism since May 8, 2008), and fell to 21.60% bears (the lowest level of pessimism since January 12, 2006).

The bears regularly argue that the market is overdue for a downturn at least due to the elevated level in bullish sentiment, and just as I recently checked for the validity of the rumor that elevated levels in (non-)commercial traders’s net short / long positions in major market index futures ( Commitments of Traders ) would’ve significantly negative implications for the market’s intermediate and longer-term performance ( see COT: Commercial, Non-Commercial and Small Traders ), I thought it would be interesting to check if this assumption came about for a reason (and could be justified by the numbers).

In addition, we all know the mantra “Never short a dull market“, and it might be interesting to check is this holds true as well when the market had posted a multi-month high in the past.

(If you’re interested in a short summary only, please click here)

In order to account for absolute and relative level, I checked for the following setups:

  • HV < 3%‘: the SPY‘s annualized (rolling) 5-day (1 week) realized volatility closed below the 3.00% mark,
  • HV + High (1)‘: the SPY‘s annualized (rolling) 5-day (1 week) realized volatility closed below the 3.00% mark, and the SPY had closed at a 3-month high during the last 5 sessions,
  • HV + High (2)‘: the SPY‘s annualized (rolling) 5-day (1 week) realized volatility closed at a 6-month low, and the SPY had closed at a 3-month high during the last 5 sessions,
  • Bull 1Y High‘: the American Association of Individual Investors (AAII) sentiment survey’s percentage bulls closed at a 1 year high, and
  • Bulls&Bears‘: the American Association of Individual Investors (AAII) sentiment survey’s percentage bulls closed at a 1 year high, while at the same time the American Association of Individual Investors (AAII) sentiment surveys percentage bears closed at a 1 year low.

Table I below shows the SPY‘s historical performance over the course of the then following 1 up to 5 sessions, and 1 up to 6 months (the probability of at least 1 higher /lower close over the course of the then following x sessions, and the probability of a higher / profitable close exactly x sessions later).

Interesting to note that …

  • when the SPY‘s annualized (rolling) 5-day (1 week) realized volatility closed at a 6-month low, and the SPY had closed at a 3-month high during the last 5 sessions (Setup 3 in the middle), the SPY closed at a higher level at least once during the then following 3 sessions on all of the up to now 24 occurrences (percentage of higher close within next 3 sessions = 100%),
  • a ‘dull market‘ shows a significantly (above-average) intermediate-term bullish bias: when the SPY‘s annualized (rolling) 5-day (1 week) realized volatility closed below the 3.00% mark in the past (Setup 1), the SPY was trading at a higher level 1 month later on more than 7 out of every 10 occurrences (72.15% of the time), and trading at a higher level 2 month later on (almost) 17 out of every 20 occurrences (or 83.54% of the time), and chances for a higher close 1 and 2 months later were even better when the SPY was trading flat at a 3-month high (e.g. the SPY was trading higher 2 month later on 17 out of 20 occurrences, and 5 and 6 month later on 19 out of 20 occurrences; 4 out of 20 occurrences are relatively new),
  • and elevated levels in bullish optimism historically did NOT necessarily imply a negative intermediate or longer-term negative tendency for the markets: when the American Association of Individual Investors (AAII) sentiment surveys percentage bulls closed at a 1 year high, the SPY was trading at a higher level 1 month later on 16 out of 20 occurrences (or 80% of the time), significantly better than the random chance of 60.39% for a higher close 1 month later (and downside potential was regularly limited), and last but not least
  • when the American Association of Individual Investors (AAII) sentiment surveys percentage bulls closed at a 1 year high, while at the same time the American Association of Individual Investors (AAII) sentiment surveys percentage bears closed at a 1 year low, the SPY was always trading at a higher level 4 and 6 month later. With 4 occurrences only, this is of course nothing to read anything statistically significant into it, but at least is doesn’t support – by no means – the bear’s side.

Table II below shows all occurrences and the SPY‘s historical performance over the course of the then following 1, 21 (1 month), 42 (2 months), 63 (3 months) and 126 sessions (6 months) where the American Association of Individual Investors (AAII) sentiment surveys percentage bulls closed at a 1 year high, while at the same time the American Association of Individual Investors (AAII) sentiment surveys percentage bears closed at a 1 year low:


(* no close below trigger day’s close during next 126 sessions)

The last time the American Association of Individual Investors (AAII) sentiment surveys percentage bulls and bears were reported at a 1-year high / low was on September 16, 2010 (my release date is delayed by 1 day), and the market (SPY) was trading higher 5.15% one month later (the 1 month time frame ended a couple of days ago).

Conclusions:

From a statistical and historical point of view, the mantra “Never short a dull market” applies to a market trading at or around a 3-month high as well, and the fact that the American Association of Individual Investors (AAII) sentiment survey’s percentage bulls and bears were just recently reported at a 1-year high (e.g. as a contrary indicator) does not favor the short side of the market. I don’t want to sound too bullish, and there might be other indications (e.g. divergences between price and breadth) in favor of the hypothesis that a (intermediate-term) top is in, but at least low volatility (even in combination with a multi-month high) and elevated levels in bullish optimism are not among them.

Successful trading,

Frank

Disclosure: No position in the securities mentioned in this post at time of writing.

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Remarks: Due to their conceptual scope – and if not explicitely stated otherwise – , all models/setups/strategies do not account for slippage, fees and transaction costs, do not account for return on cash and/or interest on margin, do not use position sizing (e.g. Kelly, optimal f) – they’re always ‘all in‘ – , do not use leverage (e.g. leveraged ETFs), do not utilize any kind of abnormal market filter (e.g. during market phases with extremely elevated volatility), do not use intraday buy/sell stops (end-of-day prices only), and models/setups/strategies are not ‘adaptive‘ (do not adjust to the ongoing changes in market conditions like bull and bear markets).

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Disclaimer

The information on this site is provided for statistical and informational purposes only. Nothing herein should be interpreted or regarded as personalized investment advice or to state or imply that past results are an indication of future performance. The author of this website is not a licensed financial advisor and will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on the content of this website(s). Under no circumstances does this information represent an advice or recommendation to buy, sell or hold any security.

I may or may not hold positions for myself, my family and/or clients in the securities mentioned here. Actions may have been taken before or after information is presented, and any opinions expressed in this site are subject to change without notice.

(Data courtesy of MetaStock , and for data import, testing, surveys and statistics I use MATLAB from MathWorks)

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Comments (5)

 

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  3. Frank says:

    Frank:

    Well done! Your statistical approach is unique and pretty accurate. Good job!

    BTW, could you adopt the Disqus comment system on your blog? Many of us are already using Disqus and if your blog also uses it, we can keep all our comments in one place and it’s very convenient. I bet this will also increase the number of comments on your blog.

    Regards,

    Frank

    • TradingTheOdds says:

      Frank,

      thanks a lot for your kind words.

      Unfortunatly I receive a bunch of spam comments, requests for link exchanges (via the comment system), adversiting comments, sometimes offending comments and and and. I don’t think the WordPress comment system is cumbersome for anybody interested in a serious discussion, but makes it much easier to sort out such unwanted comments.

      Best,
      Frank

  4. TheAuctionere says:

    Frank,

    Good information. I find it interesting that the 6 month historical volatility low indicates a 70% continuation of the bull market. I wonder if then a higher volatility with recent highs would indicate a better chance of a pullback and how in general recent historical volatility can be used as an indicator at extremes.

    -TheAuctionere (Rik)

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