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.