The Efficiency of Market Activity and Why It Matters

In the last post, I outlined a way of determining when technical analysis provides us with potential information versus randomness.  Above I've charted one of my favorite indicators, NYSE TICK (red line), as a two hour oscillator, plotted against the SPY ETF (blue line) during a recent stationary regime from January 20th to the present.  The oscillator is yet another way of defining "overbought" and "oversold" conditions, different from the rate of change measure with event time depicted in the previous post.

A couple of things are evident from the chart above.  Recall that the NYSE TICK is a measure of stocks trading on upticks minus those trading on downticks across all listed NYSE shares.  What we see during the recent regime is a preponderance of positive TICK values:  the mean is considerably greater than zero.  We've been seeing net buying and that has translated into an uptrend over the period.

But let's take a closer look.  The rate of change in SPY over the course of the lookback period has accelerated.  The NYSE TICK distribution has been stable over the period, but we're seeing greater upside price change in the second half of the distribution than the first half.  What that tells us is that each unit of buying pressure is giving us greater upside bang for the buck--a market that is gaining strength.  When we see that bang for buck increasing or decreasing over time, it's an important tell regarding the ability of buyers/sellers to move the market.

I refer to this bang for buck as the efficiency of buying/selling activity.  An efficient market is one that yields a relatively large amount of price change for each unit of buying or selling.  Typically, when we see the starts of bull and bear moves, we see an upswing in efficiency.  When we see those moves topping or bottoming out, we see a decline in efficiency.  Most recently, we've seen SPY fail to make fresh highs on recent buying, the first meaningful inefficiency we've seen in a while, and a condition that has led to overnight weakness.

Momentum trades come from jumping aboard moves that are gaining efficiency.

Value (mean-reversion) trades come from fading moves that have lost efficiency.

The smart trader doesn't trade trends and doesn't fade them.  The smart trader trades the patterns that show up during stable market periods.

Further Reading:  Efficiency and Market Cycles

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