There only 5 from 50 strategies based on moving averages are inverted (it is 10% of 50); i.e. in most of the cases (90%) the classical moving averages crossover worked since 1900 till 1910. In other words, one hundred years ago the trend following strategy prevailed in the Stock Market Land. The weather in this land was made by investors. The trader's goal then and there was to find the appropriate strategy to move in the flow of the trend.
The Paradise is lost
Let us return back to our time and see what has happened in stock market land during those one hundred years. I've examined moving averages crossovers strategies using now Dow Jones Industrial Index price history for the years 2000-2010. The result is impressive:
All 50 best trading strategies based on moving averages crossovers are inverted! This fact definitely tells us that the stock market now is moved by totally different gears than a hundred years ago. The most of the money in the stock market are made not from following the trend, they are made from the reversal movement. The weather on this land is made now by trading robots that are able to handle the smallest fluctuations of the price.
Inversion Index (II)
As a measure of the stock market status (i.e. trend following or return to average), I used Inversion Index (II). It is calculated this way: the program finds the best moving averages crossovers for the analyzed financial instrument (i.e. moving averages crossovers that provide the best profit; and we analyze both classical and inverted moving averages crossovers). The program analyzes more than a thousand of different moving averages crossover combinations. Among all those moving averages strategies, the program chooses 50 the best ones and calculates the percentage of inverted crossovers. The higher percentage of the inverted strategies amount indicates that, for the chosen financial instrument, return to average strategy works better than a trend following strategy.
For example, this record means that within the analyzed period two strategies are profitable: #1 - the inverted simple moving averages crossover with periods fast=3 bars and slow=20 bars, and #2 - the inverted triple moving averages crossover fast=3 bars middle=5 bars slow=7 bars.
This index changes in 0%-100% diapason. If II index is high, it means that for the market in question there are more return to averages movements, while a low value of this index indicates that the trend following tendency is prevailing.
The advantage of this indicator is: it is very sensitive to the changes in the stock market behavior. It allows to see much more nuances than the standard R/S analysis.
History of Inversion Index
Let's look how this index has changed in time. I have downloaded the DJI price history data since the year 1890 and examined moving strategies on different 10 years intervals: 1890-1900, 1895-1905, 1900-1910 etc. For each interval, the Inversion Index is calculated. Here it is:
As you see, the inversion index was always less than 50% till 1980. Since 1985 it jumps to 89% and since that it is very high (the 50% drop in the year 2000 is caused by the big up trend in 1990s).
Now the question arises: when exactly and why this "return to averages" strategies have happened? I have calculated a more detailed diagram for this index covering 1975-1990 years:
You can see here that these changes have happened starting from the year 1981.
Why? I do not know exactly. However, the first idea that comes to my mind while thinking about the year 1981 is Reagan's reforms, especially the deregulation of the financial sector (summer 1981). The new big player came to the stock market, automated trading systems started to be developed, and this fact totally changed the landscape of the stock market land. Inversion Index has pointed this change very precisely, up to a year.
Here you can download the Excel worksheet with these tables.
July 10, 2010