The stock market has a habit of mean reversion, which means that stock prices tend to return to their average price over time. This is because there are many forces at work in the market, including both buyers and sellers, and these forces tend to balance out over time.
Let’s look at the following scenario: The market is starting the week higher, here is how that has played out historically.
If the week opens higher, will stocks be prone to mean reversion and go lower during the week, despite the long-term tailwind?
However, mean reversion does not happen instantly. It can take days, weeks, or even months for a stock price to revert to its mean. This is why you need to backtest, but mean reversion trading strategies have worked well for stocks over the last three decades.
The Market Is Starting The Week Higher, Here Is How That Has Played Out Historically
Let’s make the following trading rules for S&P 500 (SPY):
- Today is Monday,
- Today’s open is higher than yesterday’s close (normally a Friday, a Thursday if Friday was a non-trading day),
- If the first two bullet points are true, then buy the open.
- Sell at the close on Friday (the end of the week) or after 5 trading days.
This is very simple to backtest. Here’s the equity curve:
The average gain is 0.16%, which is less than any random week. The chart shows us that the bull market from 2010 makes it a profitable strategy, perhaps fueled by quantitative easing. However, even in 2022, when the stock market fell, this was a profitable strategy (8% for the year).