The very first thing I analyze when I am creating my daily trading plan is the current market classification.
The reason? Because, depending on which scholar you read, the market itself contributes as much as 50% of the return of individual stock gains/losses. It makes sense to me then that the most importnt single factor should be the first place to research.
If you only get one thing right, it should be the current market condition.
I look at market condition in 2 time dimensions: Long term and Intermediate term. The time periods I chose are specific to the way I trade and the typical time periods I look to hold individual positions. I believe that your time frame should affect how you look at the market. I believe one size fits all strategies are not well suited for individual success. To that end, I consider long term to be the last 180 days and short term to be the last 10 days.
I look at long term market condition in 2 dimensions: Price level and Relative Volatility. Without going into the specific techniques I use to classify individual states, suffice it to say that I have 3 price categories: Bull-Sideways-Bear, and 3 volatility conditions: Quiet-Normal-Volatile. This creates a 3×3 matrix, with 9 possible market condition states. (See table below)
Looking back at the last 13 years of S&P 500 price data (that’s as long as the S&P ETF: SPY, has price data available), I analyzed the statistics of the returns of the marketfor the next day based on the current market condition as defined, and concluded that there were distinct differences in the results for each of the 9 states. It turns out that there are only 4 of the 9 states where, on average the following days return is positive.
This is an extraordinarily important piece of information to know when looking at trading opportunities for the following day, especially if your trading instrument or “target” is strongly correlated to the US large cap market. The image below is an example of the market clasification matrix in action. It shouldn’t surprise you to see the market is currently (as of Oct 4, 2008) in Bear Volatile: the worst condition for expected returns.
What’s important to note is that my analysis model classified the market as Bear Volatile on Sept 9, and has remained there ever since. The market is down well over 10% in that time period. It’s down over 20% since entering Bear Quiet mode on June 03, 2008. Being alert to market condition can prevent those kinds of losses from occurring and add tremendous value and insight to any long term investment program as well as inform short term trading strategies.
