Paratrade Systems Weekly Research News

16 Feb

How common are fearless rallies?

During the last five days, we have seen a solid rally – over 60 S&P points. This came with no help from bonds and it’s been a long time since we had a shock that purged the market of long positions. Market fear has fallen to very low levels and yet the rally continues. As I have been writing in the daily report, my favorite measure of fear could still be lower and has in fact failed to fall as much as one would expect given the up move.  Here’s what it looks like:

Fearless Rally 1

I want to study fearless rallies to see if these kind of rallies are common enough that we should question my analysis To begin, we need to divide up the world into three parts:

  1. A bear market where the close< 200 day MA
  2. A bull market (>200 day MA) where it is <=20 days since we had a shock
  3. A bull market where we are more than 20 days since that shock.

I shall define a shock in two ways:

  1. Low< 3 true ranges below yesterday’s close
  2. Close< Highest close of the last 10 days minus 4 true ranges

These numbers are somewhat arbitrary but I am looking for a combination of extremity and frequency and they will do for this analysis. I then want to look at returns when the Fear/Vol. measure is within the band that it has been in just before and during the recent rally (.03-.06).

Fearless Rally 2

This 200 day MA filter reasonably takes care of protecting investors over the last 12 years and little is missed by holding the market when the close is below that average (only 46 points). Now let’s look at shock effects:

Fearless Rally 3

These are the returns earned when Fear/Vol is low (as described) and we are close to a shock (red) and far from one (blue). In both cases, it is hard to make money since fear is so low but the bull market has been powerful and these shocks matter. Even when fear falls quickly the shock effect lingers in the minds of investors. That is why returns are still positive despite the absence of fear.

If we have no fear and we are far away from a shock then we are truly in a difficult position. If bonds are rallying then we might have a source of energy, but they are not. We have seen such rallies before:

  • Feb. 2015
  • May 2014 (when we were getting good bond support)
  • December 2010

Other than those three cases we never see rallies longer than a few days that are bigger than 20-25 points. Yes we missed this rally because we are driven by probability style analysis. The approach appears to be valid and of course, nothing is perfect so … it makes more sense to wait for more logical entry conditions.

In the meantime, we can wait to get short by looking at the first image where you can see that Fear/Vol can and often does go even lower than it is now.

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