Some qualitative aspects of market behavior can be understood via trader behavior. Broadly speaking there are two types of traders - those that react to asset price, and those that react to trend (first derivative of asset price). We shall call the first type mean-reversal traders (MR) since they tend to buy low and sell high which creates a stabilizing (mean-reversal) effect on the asset price. The second type of traders are trend-followers (TR) since they tend to follow the current price trend, i.e. buy when price is rising and sell when price is falling, which tends to create a positive-feedback effect that solidifies or at times boosts the current market trend.

Three scenarios:

  1. If the market is dominated by MR traders, then the price will tend to stay flat, i.e. the first derivative of price will be small or near-zero. TR traders will not be interested in participating in the market. Thus, flat, consolidating markets are MR dominated.

  2. If the market is trending up strongly, MR traders will be very quickly priced out of the market. Thus market with a strong uptrend are TR dominated.

  3. If the market is trending downwards, both MR and TR traders will participate and we expect market participation and thus traded volume to be the highest. The mixing of MR and TR behaviors also makes this type of market more difficult to understand than scenarios (1) or (2).

We can use the (absolute value of) daily return as a measure for trend strength and P/E ratio as a measure for asset price level. Then from the above discussion we expect market activity, measured using average traded volume, to be highest when P/E is low and daily return is large. We expect the market to be MR dominated when P/E is low and daily return is small, and TR dominated when P/E is high and daily return is large. Lastly we expect almost no activity when P/E is high and daily return is small since neither MR and TR traders would want to participate in such a market. This is indeed seen to be true for SPY (using 20 years of historical data):

assets/img/MR_TR_phase_diagram.png

The horizontal and vertical lines indicate the median values of the two axes and divide the graph into 4 quadrants. We can see that the upper-left quadrant is the brightest while the lower-right quadrant is almost completely dark. The SPY market also appears to be more TR-heavy (upper-right) than MR-heavy (lower-left), meaning more traders react to the trend of SPY rather than the price level.

In fact this graph can be used to understand which phase (trending or mean-reverting) the market is currently in. Since a MR-dominated market is a mean-reverting market, if the market is in the lower-left quadrant it is likely to be in the mean-reverting or consolidation phase. Similarly if the market is in the upper-right quadrant, then it is TR-dominated and likely to be in a trending phase. As a trader we can pick our strategy accordingly given this information.