Stock prices tend to move in trending patterns. This is a simple idea that may, or may not be supported by evidence. It really depends on how you frame the question and what time frame is presented. That’s because prices also tend to revert to a mean or average price. This interplay of price trend and price reversion is a fundamental dynamic of the market. It’s also the window dressing for evidence of randomness that underpins market price patterns.
It’s easy to not recognize randomness when we focus so much on trend and reversion. A core mechanism for human understanding is our ability to identify patterns and formulate responses to them. Indeed, much of our learning is dependent upon pattern recognition. Why shouldn’t our understanding of the markets be based on the same formulations?
Many successful trading strategies are based on pattern recognition. Whether fundamental or technical in nature, these systems win when the precepts of their approach match what the market is delivering at any particular span of time. Market is trending: systems based on price trend patterns win. Market is reverting: systems based on price reversion patterns win. A truly intelligent trading system would know how to recognize the difference between the two and when to apply either a price trend system or a price reversion system. (Orpheus Risk Management Indices (RMI) is one such intelligent system http://www.orpheusindices.com/)
However, attempts to predict outcomes in a world of true randomness cannot be absolutely defended, by definition, no matter how intelligent. Looking for patterns in randomness brings us to Chaos theory and fractal mathematics, which explores the transitions between order and disorder in deterministic systems dependent of initial conditions.
This is heady and fascinating stuff that has a growing influence on financial markets analysis, but how does a stockpicker fit in all this? It’s no wonder that the era of the stockpicker is quickly transforming into algorithmic and machine learning systems increasingly favoured by capital markets money managers. That’s all well and good for highly capitalized institutional shops, but what about the little guy?
The Stock Trends Inference Model (STIM) is an attempt to reconcile randomness in the market with evidence of price patterns. It is a simple application of statistics to Stock Trends categorical indicators that answers some basic questions about certain trend characteristics. Examples of these questions include: If the price momentum of a stock is relatively high and it has been in a bullish trend for a relatively long period, will the price momentum continue, and for how long? If a price trend has changed from bearish to bullish, what are expectations for price momentum going forward? If a stock breaks out of a bearish trend, what are the probabilities it will it retreat?
All of these questions are asked with the assumption that the answers provided are independent of the present broad market condition. That is, we want to know return expectations regardless of whether the market is in a bull or bear trend. Why? Because we cannot know whether the present trend of the market will persist. If we make an assumption that it will, then our measurement of the expected returns of an individual market (stock, ETF) will be imprecise.
This is important. When we take a measurement of a particular market condition - as represented in the combination of Stock Trends indicators in each weekly Stock Trends Report for individual stocks and ETFs - the observations of similar market conditions will take place across time periods that span the entire population of observations. Each observation occurs in varying broad market trend phases. In this respect, the Stock Trends Inference Model is broad market agnostic.
For that reason, the base measurement of returns is relative to the historical random returns of stocks, which is about 8% annually, and specifically equate to the following expected returns for each of the relevant periods Stock Trends measures: 0% 4-week return, 2.19% 13-week return, and a 6.45% 40-week return. If a trend condition for a particular stock/ETF does not provide statistical evidence that it can beat these base return expectations, then we cannot say anything definitive about its return expectations. However, if there is a deviation from the base return expectations we can say that the current trend characteristics indicate either over-performance or under-performance projections. This is the objective of the Stock Trends Inference Model.
A good starting point for Stock Trends Weekly Reporter subscribers is a weekly review of the STIM Select stocks report. It shows the stocks and ETFs that have the best statistical trend characteristics. The report is ranked by the 13-week return expectations.
The current NYSE STIM Select report, as an example, includes the SPDR S&P Metals & Mining ETF (XME-N). The Stock Trends Report for XME shows that the ETF is 7-weeks into a Weak Bullish trend; that it is underperforming the S&P 500 index by 12% over the past 13-weeks and underperformed the broad market index last week (RSI 88 - ). It’s been in a Bullish category for 54-weeks but has been retreating since February.
The statistical model shows that there have been about 277 observations of stocks and ETFs that have shared these characteristics or have had similar Stock Trends indicator combinations. From this sample we can make inferences about the expected returns of XME over the next 4-week, 13-week, and 40-week periods.
The green sample density plots show the distribution of returns for the three separate periods following the observation. Most generally, these distributions will be centered around the mean random return expected for each period ( 0% 4-week return, 2.19% 13-week return, 6.45% 40-week return). However, certain Stock Trends indicator combinations yield sample distributions that deviate from the expected mean random returns. The sample distribution of returns generated in the XME sample deviate in a positive way.
For the 4-week period 53.8% of returns in the sample are greater than 0%, the expected 4-week return. By employing statistical inference methods to estimate the population mean, we can estimate that the expected (or mean) 4-week return for XME is 1.8%. More importantly, with our assumption of a normal distribution of returns - a defining attribute of randomness - we also can estimate that XME has a 56.5% probability of having a return greater than the expected 4-week return of a randomly selected stock. This in comparison to the 50% probability we would expect from a random stock.
Similarly, the 13-week expected return for XME is 7.2%, with a 60.8% probability of besting the base period expected return of 2.19%, and the 40-week expected return for XME is 21%, with a 64% probability of beating the base period expected return of 6.45%. All better probabilities for beating the returns of a randomly selected stock.
While even a 64% probability is better than a 50% probability implicit in a random selection, it’s still only a 64% probability. There is a 36% probability that it will underperform the expected return of a randomly selected stock. If you know anything about chance, you must know that a 36% chance of being wrong is more than enough to lose your shirt.
However, the Stock Trends Inference Model does tell us that XME is currently in a trend and momentum position that historically has exhibited tendency toward positive returns in the subsequent period. This gives us some confidence in making a directional trade, and can be used as the foundation of a derivatives trade (options) that further improves a trader’s probability of making a profitable trade.