Part I introduced the concept of SMA Distance – the distance between a Simple Moving Average and the index. What can the current SMA Distance tell us about future returns?
Distribution of future returns
To answer this question, we will bucket the SMA Distance into 5 bins (quintiles). The first quintile will have the lowest distance and the fifth one will have the highest. Since a rising market will have negative distances, the first quintile will mark a rising market and the last quintile will mark falling markets. We will bin 50-, 100- and 200-day SMA distances into quintiles, then plot the distribution of the subsequent 20-, 50- and 100-day returns for each.
50-day SMA distance quintiles vs. subseqent 20-, 50- and 100-day returns:
100-day SMA distance quintiles vs. subseqent 20-, 50- and 100-day returns:
200-day SMA distance quintiles vs. subseqent 20-, 50- and 100-day returns:
The negative tails on the 20-day returns are interesting. On the 50-day and 100-day charts, you will notice that the negative tails on 20-day returns are lot more on the 5th quintile than on the first – showing that in the short term, markets trending higher tend not to reverse course sharply. But if the market is way off its 200-day SMA (the last chart,) the first quintile seems to represent over-extended markets that are prone to steeper drops.
We will test this theory on data from 2006 onward in our next post.
Code and charts are on github.