"IF YOU THINK THIS IS OVER THEN YOU'RE WRONG"
-Radiohead, 'Separator'
Anyone who's ever inadvertently paid attention to an investment advisor commercial or bothered to read a mutual fund prospectus is familiar with the phrase, "past performance is not indicative of future results." This is legal jargon for 'you can't sue us if we lose all your money.' In reality, however, past performance is used ad nauseam to predict future results, especially in today's world of ubiquitous data driven models.
Right now, past performance is indicating the blasts of selling and accompanying spikes in volatility in equity markets this past week do not appear to over. Looking at past episodes of market turbulence, there are quantifiable trends that tend to indicate when a market has found its bottom. Before we actually try to find the bottom of this market, let us first define a few key concepts of quantitative finance.
QUANTITATIVE FINANCE - 101
Like it or not, modern markets are driven by computer algorithms that trade for a wide variety of functions. Many are used for noble purposes such as managing positions in large mutual fund, but then again many are not. Proprietary trading algorithms look for trends in data to suggest which way the price of a security or market is likely to move. A small sample of some of the things they look for are:
DATA VISUALIZED - PICTURE THIS
Data visualization enables us to see the data points defined above in a way that makes some intuitive sense. Below, are charts from previous breakdowns of the S&P 500:
October 2014:
January 2016:
The October, 2014 breakdown seemingly came out of nowhere as the drop started when the index was above its moving averages and quickly proceeded to breach all support levels and breakdown. The January, 2016 breakdown, however, was easier to see coming as indicative technical patterns developed over time.
Now, here's a look at today's market (the time of this writing is approximately 2:40 EST, 2/9/18):
Of the two prior examples, today's market more closely resembles the October 2014 breakdown as the price action has moved quickly below all support levels. This is not to say that it was unpredictable, however. Prior to Monday's opening salvo, the variance of the S&P over its moving averages was near historic highs as was the variance of the 20-day moving average over the 50-day moving average. The market entered a classic 'reversion' pattern last last week in fact.
WHAT THE NUMBERS ARE TELLING US
As of now, the numbers suggest the market has not yet formed a bottom for two basic reasons.
IT'S GROUNDHOG DAY
Markets are, of course. impossible to predict and could very well begin to recover the moment after I publish this. However, data driven models are built on events of the past and we've seen these types of patterns before. As the market continues to establish new lows without much support in sight, it seems, unfortunately, that it appears to be pointing to six more weeks of winter.
-Radiohead, 'Separator'
Anyone who's ever inadvertently paid attention to an investment advisor commercial or bothered to read a mutual fund prospectus is familiar with the phrase, "past performance is not indicative of future results." This is legal jargon for 'you can't sue us if we lose all your money.' In reality, however, past performance is used ad nauseam to predict future results, especially in today's world of ubiquitous data driven models.
Right now, past performance is indicating the blasts of selling and accompanying spikes in volatility in equity markets this past week do not appear to over. Looking at past episodes of market turbulence, there are quantifiable trends that tend to indicate when a market has found its bottom. Before we actually try to find the bottom of this market, let us first define a few key concepts of quantitative finance.
QUANTITATIVE FINANCE - 101
Like it or not, modern markets are driven by computer algorithms that trade for a wide variety of functions. Many are used for noble purposes such as managing positions in large mutual fund, but then again many are not. Proprietary trading algorithms look for trends in data to suggest which way the price of a security or market is likely to move. A small sample of some of the things they look for are:
- Support/Resistance levels - Support/Resistance levels are prices where securities have displayed a prior tendency to not breach, either moving up (resistance) or down (support).
- Trend Price - Just as the name suggests, data models use trailing averages of prices to define trends; these are also called 'moving averages'. Models designed for short holding periods will give more weight to shorter trend data - often measured in minutes - alternatively, models designed for longer holding periods will use trend prices that are measured in days; two popular trends are the 20 and 50 day moving averages.
- Breakdown - This is a term I use to describe when prices breach a support level and move down at an accelerated pace.
- Variance - This is a measure of the relative distance between two points... this can refer to the distance between a current price and a trend price or to two trend prices.
- Derivative - Anyone who's taken a calculus class will surely recall that the definition of 'derivative' is the rate of change at a point.
- Second Derivative - This is the rate of change of the first derivative, or the rate of change of the rate of change.
DATA VISUALIZED - PICTURE THIS
Data visualization enables us to see the data points defined above in a way that makes some intuitive sense. Below, are charts from previous breakdowns of the S&P 500:
October 2014:
January 2016:
The October, 2014 breakdown seemingly came out of nowhere as the drop started when the index was above its moving averages and quickly proceeded to breach all support levels and breakdown. The January, 2016 breakdown, however, was easier to see coming as indicative technical patterns developed over time.
Now, here's a look at today's market (the time of this writing is approximately 2:40 EST, 2/9/18):
Of the two prior examples, today's market more closely resembles the October 2014 breakdown as the price action has moved quickly below all support levels. This is not to say that it was unpredictable, however. Prior to Monday's opening salvo, the variance of the S&P over its moving averages was near historic highs as was the variance of the 20-day moving average over the 50-day moving average. The market entered a classic 'reversion' pattern last last week in fact.
WHAT THE NUMBERS ARE TELLING US
As of now, the numbers suggest the market has not yet formed a bottom for two basic reasons.
- Moving Averages Still Need to Flip - It's hard to believe but the 20-day moving average is still above the 50-day as the shorter dated trend line is descending at a faster pace than the longer (in predictive analytics, this is known as 'trending vs tracking'). One sign of a bottom is when the gap between the averages begins to close, but with the shorter trend ascending relative to the longer. Absent an unforeseen historic rally, it is going to take time for this pattern to develop. The January, 2016 market did not bottom until this phenomenon occurred.
- The Second Derivative of the 20-Day Trend Line - One of the first technical indicators of a market bottom is the 20-day trend line's convexity becomes positive. This was evident in both the October, 2014 and January, 2016 recoveries. In fact, it was the changing of this metric from positive to negative last week that signaled a reversion was likely. Now, the convexity is negative and strongly negative at that. Much like the moving average variance gap, it will take time for this metric to work itself out.
IT'S GROUNDHOG DAY
Markets are, of course. impossible to predict and could very well begin to recover the moment after I publish this. However, data driven models are built on events of the past and we've seen these types of patterns before. As the market continues to establish new lows without much support in sight, it seems, unfortunately, that it appears to be pointing to six more weeks of winter.
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