No doubt traders will hear about a possible “Santa Claus Rally” many times in the next few weeks. When looking at the S&P 500, though, I found the best week in December to be option expirations week. The edge has been especially pronounced over the last 24 years. During that period the market has closed the week higher about 81% of the time.

About a month ago I showed how the S&P 500 has performed following days where the market dropped 5% or more. In most cases such a strong reaction was an overreaction and the market closed above the close of the 5% drop day shortly thereafter.

Since I showed that table a month ago we have had SIX more 5% drops. Five of the six saw the same pattern with some kind of bounce in the next few days. Below I’ve updated the table which lists all 5% drop days and whether they closed above the 5% drop day close in the next week.

I decided to do a follow-up on yesterday’s post and include some pictures. What we’ll uncover through this exercise is that the edges aren’t quite as cut and dry as they might appear by simply looking at the end results. (Hint: they almost never are.)

Rather than view a table I’ve put together 4 equity curves based on owning the S&P when it was in a certain quadrant. I’ve also changed the test to buy $100k worth of the cash index rather than 1 share. This effectively gives us percentage returns. It also changes the end results slightly so you’ll need to be aware of the differences.

First let’s look at owning the S&P when it’s above the 200 and 50 day moving averages. Recall from yesterday that since 1960 the market has spent 53% of its time in this quadrant:

Over time this market position has been a steady winner. It has sat out bad drawdowns and has had some nice upside participation. I find it interesting that it peaked in 2000, though. The most recent bull market of 2003-2007 failed to see much headway at all when the market was above these two lines. I would classify it as a weak bull. It was extremely rotational and saw little in the way of buying enthusiasm when the market began hitting new highs. While I observed these characteristics at the time, this is the first time I’ve viewed it in this manner.

Now the 2nd quadrant – above the 200ma and below the 50ma. Recall from yesterday that since 1960 the market has only spent 15% of its time in this quadrant:

Here we see that this was not a bullish quadrant to be in until the bull market of the 80’s began. During the 60’s stocks spun their wheels in this area and during the 70’s they lost money. The total gains are not as large here as in Quadrant 1 when looking at percentage gains. Yesterday they were larger when looking at point gains. That’s due to the fact that this quadrant did its losing early on when the points were low and its winning more recently when the points were high. Thus the point gains were a bit exaggerated.

The exaggeration is not a bad thing. In fact, using points rather than %’s basically front weights more recent developments. Think of it as an Exponential Moving Average vs. a Simple Moving Average. The gains since 1980 have been much greater per day in here than in Quadrant 1. The total percent gained is almost the same over that time and the market has spent over 3 times the amount of time in quadrant 1 vs. quadrant 2. (55% vs. 16% since 1980) Again, Quadrant 2 outperforms Quadrant 1 although its not as obvious just from the graph. Short-term pullbacks in long-term uptrends have made for good buying opportunities.

Now Quadrant 3 – below 200ma and above 50ma. The market has spent its least amount of time here – only 9% of days since 1960:

This has basically been a pass-through quadrant. When the market is emerging from a bear and beginning a new bull some gains are to be found here. I also broke this down by where the quadrant was entered – did it come from 1 or 4? Not surprisingly almost all gains were realized when this quadrant was entered from Quadrant 4 and moving up.

Now let’s look at Quadrant 4 – below the 200ma and below the 50ma in which the market has spent 23% of its time.

A few spikes up when the market was emerging from a bear market or steep correction. Other than that it was not a place you wanted to bet on the long side. When the market enters this quadrant from above it’s probably best to adjust your strategy and trade in bear market mode.

A big take-away is that the market evolves over time. Sometimes this is missed when looking only at tables. Sometimes equity curves are able to capture this well. By understanding how the market has reacted in the past, especially the more recent past, we can better adapt our trading to take advantage of its movements.

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Other bloggers who have written about evolving markets in detail include Michael Stokes at MarketSci. (His S&P 500 vs. Consumer Discretionary post is one recent example.)

Dr. Brett Steenbarger of Traderfeed also discusses market evolution and he had an especially interesting post today about how reaction to bearish momentum days has changed over the last several years.

An interesting conversation I had with another trader a couple of weeks ago inspired me to take a look at market performance based on the market’s position relative to its moving averages. Below I broke down the position of the market into 4 quadrants: 1) Above both the 200ma and 50ma, 2) Above the 200ma and below the 50ma, 3) Below the 200ma and above the 50ma and 4) Below both the 200ma and 50ma. I used simple moving averages in all cases. The performance of the S&P since 1960 is shown by quadrant in the table below:

A few comments:

1) The biggest long side edge appears to be when the market is trading above its 200 but below its 50-day moving average. At this point the market is in a long-term uptrend but is not extended to the upside over the short-term.

2) There’s a clear distinction between long-term uptrend and long-term downtrend results. The simple rule of looking for long trades above the 200ma and short trades below the 200ma appears to provide an edge.

3) Going long when the market moved into quandrant 1 (> 200 and > 50) and exiting when it left this quadrant would have only been a profitable trade 29.8% of the time. The edge comes from the fact that some very big moves were caught.

4) Going short when the market moved into quandrant 4 (
In the next few days I’ll show a similar test using shorter-term moving averages.

One thing traders need to keep in mind in the current environment is that when the market is bouncing off of intermediate-term lows it is more likely to get overbought and STAY overbought than when it’s simply consolidating in a downtrend. Shorting bounces off lows typically carries an extra level of risk because of this.

Let’s look at the how the market set up as of Tuesday’s close as an example. SPY closed higher 3 days in a row. Tuesday was the narrowest range in the last 5 days. When trading under the 200-day moving average, this combination can signal the market is likely to pull back. See the test below:

The propensity to pull back is most pronounced over the first 4 days.

Now let’s break down the above results a little differently. First let’s look at times the SPY set up as above but was NOT coming off a 50-day low:

Results here are decidedly more negative than in the original study. Two days out for example there are only 18% winners.

Now let’s look at the first setup again, but this time we only want to see those trades that were coming of a 50-day low:

There is no longer a bearish edge to the setup. In fact, there appears to be a bit of a bullish one. Now 2 days out there are 82% winners. (Although instances are low and that’s not really the point.) The point is that it is much more dangerous to short a market coming off of fresh lows. This is especially true when the lows occurred on extremely oversold conditions.

While previous attempted rallies did quickly roll over the last 2 months, that’s not always the case. Examples of oversold bounces off lows that would have been especially dangerous to short include August 2007, October 2002 and September 2001.

I’ve often heard about the positive tendencies of the market to rally Thanksgiving week. So I ran a quick test:

The above results actually go through the Monday following Thanksgiving. Positive tendencies may have existed in the distant past, but over the 21-year period I looked at there doesn’t appear to be any edge – bullish or bearish.

The market rallied hard on Friday after hitting historically extreme conditions. There are reasons to be optimistic about some follow-through this week. Thanksgiving doesn’t appear to be one of those reasons, though.