ITS ALL RELATIVE

As I stand aside for the moment and await some clarity from the market (sure), I note that Dr. Brett has another interesting take on the crashing markets (seems that way anyway).

Is the sky truly falling or are we just spoiled by the recent constant upward drift in equity prices? Here is Dr. Brett's take:



"SPY was down about 2.5% over the past two days, but suppose we measure price change in relative terms? Suppose we measure price change as a multiple of the median two-day change over the past 60 days?

In this low volatility environment, the median daily price change of the past 60 days has been .47%. For all of 2006, the markets median two-day change has been .57%. Compare that to the 1996-2006 median of 1.05% and the 2002 median of 1.53%. A drop of 2.5% over two days was only about 60% above average in 2002, but more than five times the present average (5.3 to be precise).

And maybe traders don't react to the absolute magnitude of price changes, just as they don't react to the absolute reading shown on a thermometer. Forty-five degrees in the dead of winter elicits a different response than it does in mid-summer. A 2.5% drop in a high volatility market may be a much more routine event--and elicit a far more moderate response--than a 2.5% drop in a low volatility market.


If we look at what happens to the market two days after a two-day decline of 2.5% or more, we learn that the average change is .32%, but the median change is only .14%--similar to average for the sample (78 up, 69 down).

If we look at what happens to the market after a two-day decline that is more than 5.3 times the average two-day price change, we have a sample of only four. All four were up two days later by an average of 2.63% and a median 2.48%. In relative terms, the market two-days later was up by an average multiple of 2.47 times its 60-day average change, which in the current market would amount to 1.18%.


My research overall suggests that market outcomes are more skewed--and potential trading edges larger--when we treat price changes in relative rather than absolute terms.

TradingMarkets has found that viewing other indicators--such as the VIX--in a relative light is far superior to dealing with absolute VIX values. The same may well be true for price--and for many other market indicators that show different averages and standard deviations from one market period to the next."

My take is that the move of the markets on Thursday and Friday seemed larger than they actually were because we were so spoiled by the recent non-volatile slow upward drift in equity prices. So a drop in the SPY from 133 to 129, a 4 point sell off, seems huge in light of recent volatility. Keep in mind that it was just last October when the SPY dropped from 123 to 116 over about a 10 day period. After that October selloff, we again had a slow upward drift in equity prices.

The VIX shot up to the 17 area in mid October at the height of the selloff and then dribbled back down to the 11/12 area. Today, the VIX hit its high of around 15 earlier this morning and now looks like it want to start the dribble lower again.

My thoughts are that the markets will settle down after it becomes apparent that a crash is not at hand and commodities will stabilize and we will again begin the slow drift up in equity and commodity prices and a slow drift down in the Volatility indexes. Been there, Done That?