Regression to the Mean

In this post we will take a look at some of our research for those interested in understanding how we developed the SRS Risk Assessment Meter.

Before we get started it is important to observe two simple observations about stocks and markets.

Observation 1: Markets sometimes trend
Observation 2: Prices tend to regress toward their mean

Above is a chart of the S&P 500 between the years 2000 and 2002 when stocks were last in a bear market. There are two important things to note about this price chart.

1. The long term trend was down, but within that downtrend many countertrend rallies took place
2. Every single countertrend rally regressed back to the 40- and or the 50-week moving averages except one.

If you pay attention, a lot can be learned from this chart.

Here are a few observations that can be made from the above S&P 500 chart:

1. Countertrend rallies are likely to return to the 40- and 50-week averages, giving them a clear price target.
2. When the price is at the 40- and 50-week average opening new short positions can be highly profitable and risk of failure is low.
3. When the price is too far below the mean (40- and 50-week) short trades become increasingly more risky to take and trailing stops on open short positions should be tightened.

Finding the Forest Amongst the Trees

Now let's take a look at the current SPY chart and see if we can't determine why last week's sell signal failed, trapping short positions.

Last week the SPY gave us a sell signal on the day of the Fed rate cut. That sell signal failed and prices rallied on Thursday and Friday last week as seen in the daily SPY chart below.

Could the sell signal failure above have been predicted? Maybe, maybe not. But if we take a look at the weekly SPY chart we can see that risk of failure was high.

Note above on the weekly SPY chart that prices had reverted a great distance from their mean as measured by the 40- and 50-week moving averages. Prices could certainly have continued to fall lower, but risk of going short was high as historically prices tend to regress back to their mean.

The failure of Wednesday's sell signal broke the near term downtrend. This signaled that a countertrend rally is now in effect. Since historically prices tend to tag their 40- and 50-week moving averages during countertrend rallies, probabilities are high that we will continue to see the market rally (with pullbacks of course) until it reaches back to its mean.

Bottom line: It's a good idea to go lightly long on pullbacks, looking to take profit and go short when the SPY reaches the $143-$143.50 area.