Most of us have heard the expression “The trend is your friend.” At the individual stock level, many investors favor issues with good relative price momentum, those that have outperformed their peers over some past period like six or 12 months. Equity indexes can also exhibit price momentum – up trends tend to continue, as do down trends.

A 2012 paper called “Forecasting Stock Returns in Good and Bad Times: The Role of Market States” by Huang, et al has a slightly different take on price momentum at the equity index level. The authors argue that dividing the market into two states – good times and bad times – enhances the ability of price momentum to forecast future market returns. During good times stock indexes tend to be mean reverting, meaning that positive returns are often followed by brief pullbacks (and just the opposite for negative returns). Meanwhile, in bad times, a negative return is likely to be followed by another negative return, and positive returns, by another positive return. In short, it seems that “the trend is your friend” in a statistical sense is a bad time phenomenon.

The authors looked at three indicators of good and bad times, including periods of recession and expansion, stock market returns over the past six months and the level of the stock market compared to its 200-day moving average. All three turned out to be useful. Recession and expansion do not help for forecasting, however, because recessions are often identified months after they begin. Of the two remaining indicators, we focus on price compared to the 200-day moving average because it is simple and has for decades been a well-known stock market indicator.

Good times, by this measure, are whenever the level of the stock market is at or above its 200-day moving average. Bad times are periods when the stock market is below its 200-day moving average. So now we have two states – good times and bad times. The idea of the paper is that momentum is negatively correlated with future market returns in good times and positively correlated in bad times.

The authors propose the past year’s return on the stock market less the 30-year average return as their momentum indicator. They scale this time series by a measure of stock market volatility. In a regression with only one state, the beta coefficient for the momentum predictor is positive. In the two-state model, the beta coefficient is negative in good times and positive in bad times.

To illustrate how much the relationship varies between good and bad times, we looked at monthly data from 1980 through June of this year. As of the last trading day of each month we used price and the 200-day moving average to determine whether the market was in a good or bad state. Out of 450 months, 332 were “good” and 118 were “bad.” The correlation between the momentum predictor and the return in the month following was -0.125 for good times and +0.157 in bad times. Both correlation estimates were statistically significant.

Intrigued by the paper, we tested whether the two-state model could improve a momentum indicator in our ensemble of models. We confirmed that it helps and incorporated the idea into our investment process. So it seems the trend is your friend, but more so in bad times.

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