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The Four Market Shocks

In the last 63 years there have been four major shocks after which volatility increased substantially. The last shock due to the financial crisis caused a volatility increase to new highs marking an alarming trend for the future. The increased volatility and the vanishing serial correlation in the last five years have had a negative impact on low frequency technical trading. Traditional trading methods that rely mostly on serial correlation and on low volatility of daily returns are becoming unprofitable. 

 

SPX_20130425

On the daily chart of S&P 500 above the first indicator pane shows the rolling 1-day lag 120-day auto-correlation. The downtrend since the 1970s is marked on the chart. By the top of the market in 2007 the serial auto-correlation had vanished, possibly due to mean-reverting robots taking control of the game. I have talked about this trend in another post and I have argued that it is the main cause of the failure of traditional technical trading methods such as indicators and chart patterns.

The four major shocks in the last 63 years are marked on the lower pane that plots the rolling 756-day standard deviation of daily arithmetic returns. The mean is indicated as 0.92% During the first market shock after the oil crisis of 1973 the standard deviation peaked at 1.15%. Then after the 1987 crash aftershock, the standard deviation peaked at 1.48%. The same peak was reached after the dot-com bubble bust. Then, the fourth shock came with the financial crisis and standard deviation jumped to 1.94%. This has created an alarming pattern pointing to an uptrend in the standard deviation. This parameter has to do with how difficult it is to trade the market with directional or mean-reverting techniques and not VIX, which just follows the inverse of price.

The increase in the standard deviation of daily returns after 2007 that lasted up to recently and with current levels above the longer-term mean is one major cause of trend-following problems along with the indisputable fact that trend durations have decreased substantially from their longer-term mean across the equity index board.

The conclusion is that most traders may have to change their trading style or wait until the market returns to normal operation due to reflexivity.

Disclosure: no relevant position at the time of this post and no plans to initiate any positions within the next 72 hours.. 

Charts created with AmiBroker – advanced charting and technical analysis software. http://www.amibroker.com/ 

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Related posts

https://www.priceactionlab.com/Blog/2013/04/more-evidence-that-equity-index-trend-following-has-become-difficult/
https://www.priceactionlab.com/Blog/2012/08/further-analytical-evidence-that-vix-just-tracks-the-inverse-of-price/
https://www.priceactionlab.com/Blog/2012/12/the-main-cause-of-failure-of-some-popular-technical-trading-methods/

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