Market Compression Reaches Extreme !!!

PRICE BEHAVIOUR AND MARKET COMPRESSION !!!

Certain Traits of Price Behaviour

1.       Trouble runs in streaks – Market turbulence tends to cluster. The size of price changes clearly clusters together. Big changes often come together in rapid succession, and then come long stretches of minor price changes.

2.       Markets have a personality – Prices are not driven solely by real world events, news and people. When investors, speculators, industrialists, and bankers come together in a real marketplace, a special, new kind of dynamic emerges – greater than, and different from, the sum of the parts. Fundamental process by which prices react to news does not change.

3.       Markets mislead – Patterns are the fool’s gold of financial markets. The power of chance suffices to create spurious patterns and pseudo-cycles that, for the entire world, appear predictable and bankable. But a financial market is especially prone to such statistical mirages.  Bubbles and crashes are inherent to markets. They are the inevitable consequence of the human need to find patterns in the pattern less.

4.       Price levels/changes exhibit some kind of irregularity regularly. The charts sometimes rise or fall in long waves, or with small waves superimposed on bigger waves. But none of this phenomenon – clusters of volatility, or irregular trends – resembles any of the cycles, waves, or other patterns that characterize those aspects of nature controlled through well-established science. There are no familiar sine or cosine waves, with regular periods.  These peculiar patterns cannot be predicted; and so humans who bet on them often lose. Yet there clearly is a system to them. It is as if the charts have a memory of past. If the price changes start to cluster, or the prices themselves start to rise, they have a slight tendency to keep doing so for a while – and then, without warning, the stop.

(Source - The (Mis)Behaviour of Markets - Benoit B. Mandelbrot)

Nature of Price movement throughout history remains constant, it clusters.  Nature of clustering might change, but it will cluster. Natural/Business cycles are smoother and clustering is far apart, while markets which are not allowed to clear and constantly intervened (one we are having since 2008-2009 crises), clustering is frequent and sharper.

Volatility/Price move clusters (90-95% of price moves happen in 5-10% of time) , however in order to be active we tend to trade regularly and in process use energy and money. Trading regularly and trying to capture all moves, mind becomes monotonous and we trade big moves and small moves alike. Ideally big moves should involve bigger bets and small moves should have smaller bets. 

Clustering is very natural to almost everything....

1) Nifty

Nifty % returns since last 2 decades...Most of the gains or losses are accounted by 2 mths....

2) In the 1980s, fully 40% of the positive returns from S&P 500 index came during 10 days – about 0.5% of the time. 

3) Look at a map of gold deposits around the world: you see clusters of gold mines – in South Africa and Zimbabwe, in the far reaches of Siberia and  elsewhere. Same for oil and other natural resources

4) Top 1% controls 42% of financial wealth in America..similar statistic will apply to other countries in terms of wealth distribution

5) From 1986 to 2003, the dollar traced a long, bumpy descent against JPY. But nearly half of that decline occurred in just 10 out of 4695 trading days. Put another way, 46% of the damage to dollar investors happened on 0.21% of the days. 

6) Such clustering can be applied to everything in daily life to marriage life as well....Most of the love (physical) between couples happen during initial years (or months) of marriage then it's all  infrequent love....

7) Large part of population lives in very small part of place....Mumbai might account of 0.001% in terms of area but will account for 2% of population. 

There can be plenty of more examples...

Applying same to Market Trading...

1) Best way to play this clustering is through options...because it allows one to play magnitude of moves irrespective of direction..

2) Timing is very very crucial to this because very small time accounts for very large part of the move....as we have seen in above Nifty movement...2 Months accounted for almost entire year's movement consistently for last 2 decades...

3) If one can be sure of direction then getting those clustered movement is immensely beneficial....however even if are able to understand that markets are about expand its movement...playing that expansion can also be very beneficial...

2012 - Compression of Markets (Nifty - India) reach extreme....2013 will it be to the other end ??

 Big Yearly Compression

1) Number of weeks with movement of more than 4%

2012 had lowest number of weeks with movement of 4% or greater. There were only 3 weeks with movement of 4% or greater.  Average since 1994 is 11.

2) Summation of High-Low Monthly range

a) The above table provides high low range on monthly basis since 1995. December 2012 so far has the  lowest high low range (1.4%) since 1995. Previous lowest number was 2.34% in August 2001.

b) Red box indicates high low range of less than 3%. each one of them were followed by sharp rise in range in the following month.  Yellow box indicates range between 3-4%, while pink box indicates range 4-5%. Typically such compression are followed by at least 5%+ high low range in the following months.  Average range expansion following red and yellow box is 9%.

c) 2012 was the lowest in terms of summation of range score since 1995. Score stood at 74, while previous low was 76 in 2012. One thing which stands out about the market since 2008 is 2010 was the most compressed year since 1995 and with gap of one year i.e. 2012 turned out to be the most compressed year since 1995. Thus, 2 years - 2010 and 2012 have been extremely compressed which is a very rare thing.

3) High Low Range for the Year

a) 2012 has been the lowest in terms of high low range for the year at 27.8%. Previous low as 29% in 2002.

b) 2012 is also the year wherein in terms of absolute % movement, difference between high low range and close-start range, is lowest.

Monthly Compression

Though yearly compression will inevitably result in monthly compression, sending few set of data points to show monthly compression as well.

1) Summation of Absolute (%) daily movement on Monthly Basis

a) the above table provides summation of absolute % move  on daily basis for each month. for eg summation for December 2012 stood at 6 (over period of 16 trading days), giving daily average move of 0.38% or 20-22 Nifty Points.

b) Average Monthly score for 2012 stood at 15, which is lowest since 1994 (previous low of 17 each in 2010 and 2002)

Other Factors...

VIX and options pricing have fallen similarly since June 2012.

Central Banks have largely killed volatility since June 2012, resulting in extremely compressed market for so long. Given natural tendency of market to revert to mean, 2013 could be very volatile.