TREND-FOLLOWING TO PROSPERITY? DOUBTFUL

I made the case that Indian equities are now undervalued based on price to nominal GDP, but the market is still not trading at the extremes seen around 2002-end (SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS)- those valuations imply a SENSEX level of about 7500. Where the final bottom lies will depend upon the evolution of global risk appetite based on the future course of economic and earnings data. Considerable uncertainty remains about whether policy stimulus will work given the continued problems in the banking sector. Absent any further shocks, I am leaning toward a scenario where the substantial fiscal response along with improvement in credit markets will lead to a feeble resurgence in late 2009 or early 2010. Markets will turn before that, but given the substantial uncertainty, I am looking for ways to avoid the downdraft should the recovery not materialize. To this end, I tested several technical rules that could help in playing this turning point profitably.

The results are preliminary, but based on monthly index data it does not seem that simple trend following strategies would be of great help. There is no statistical evidence of either momentum or reversal in monthly return data for the SENSEX and BSE-100. Market breadth – characterized by the advance/decline ratio - does not seem to have any predictive power either. The option market – call to put ratio - seems to have some contrarian relevance.

TREND IS YOUR FRIEND? NOT SURE

I tested for linear dependence in monthly returns for both the SENSEX and BSE-100 (April-2001 to March-2008). The results do not indicate any tendency for either momentum or reversal.

SENSEX

Return (t) = 1.9% + 0.06*Return (t-1)

BSE-100

Return (t) = 2% + 0.05*Return (t-1)

The regressions have low R^2 and the coefficients for lagged returns are not statistically significant. So a simple momentum strategy will not be of much help in our endeavor.

What about buying only when the monthly closing value exceeds the 12-month moving average? The results are no better than a buy and hold exercise.

12-month Moving-Average Strategy: Monthly Return Statistics

Mean: 2.5%
Standard Deviation: 7.0%
No. of Months: 61

Buy and Hold: Monthly Return Statistics

Mean: 2.6%
Standard Deviation: 6.8%
No. of Months: 71

Bottom-line, it does not seem that we can simply follow the market to prosperity.

WHAT DOES MARKET BREADTH TELL US? NOT MUCH

High breadth is a sign of a healthy market that is more likely to rise. To test this hypothesis, I regressed monthly returns with one month lagged advance to decline ratio (A/D) as the explanatory variable. The results are not encouraging.

Returns (t) = 2.6% - 0.002* A/D (t-1)

The regression explains about 9% of the variation in monthly returns and the coefficient of the A/D ratio is negative but lacks statistical significance. There does not seem to be any pattern in the residuals.

To take the analysis one step forward, I tested four trading schemes:

1.If the advance/decline ratio for the month is higher than that for the last month and current monthly returns are positive, go long the market, otherwise stay out.

Mean: 2.2%
Standard Deviation: 8.2%
No. of Months: 35

2.If the advance/decline ratio for the month is lower than that for the last month and current monthly returns are positive, go short the market, otherwise stay out.

Mean: -2.9%
Standard Deviation: 6.5%
No. of Months: 20

3.If the advance/decline ratio for the month is lower than that for the last month and current month returns are negative, go short the market, otherwise stay out.

Mean: -1.9%
Standard Deviation: 5.9%
No. of Months: 21

4. If the advance/decline ratio for the month is higher than that for the last month and current month returns are negative, go long the market, otherwise I stay out.

Mean: -0.15%
Standard Deviation: 9.1%
No. of Months: 6

Market breadth does not seem very helpful in improving investment performance.

OPTIONS MARKET A CONTRARIAN INDICATOR

If the call/put (measured by value) ratio trends higher, on average, traders expect the market to rise. I tested the predictability of this technical factor by regressing monthly returns of the BSE-100 on 1-month lagged call to put ratios on the NSE. I know that the exchanges are different, but cannot think of a reason why that should bias the results.

BSE-100 Returns (t) = 5.7% - 0.008 Call to Put Ratio NSE (t-1)

The R^2 is about 18%. The coefficient for 1-month lagged call to put ratio is negative and the p-value is 0.11. It seems that the options market gets it wrong on average and we can say this with about 90% confidence.

PRELIMINARY EVIDENCE NOT ENCOURAGING; FURTHER INQUIRY REQUIRED

There are obvious qualifiers to the above analysis: firstly, the data is not enough; secondly, I used only monthly data, it is possible that the indicators work for different periodicity; and finally, there might be non-linear dependence that our simple statistical techniques failed to decipher. The results are not conclusive, but do suggest that simple trend following strategies are not likely to help us negotiate the considerable uncertainty that clouds the investment landscape.

Source: HANDBOOK OF STATISTICS ON THE INDIAN SECURITIES MARKET 2008; SEBI
Monthly data from April 2001 to March 2008