25 December 2010

Nifty : Mean Reversion?

I have always believed that market is like an elastic and rarely settles down at fair value. In bull market we see market extending much higher than fair value and in bear markets it goes much below it. Here comes the universal theory of mean reversion. Which means that in future prices should be coming back to mean.

Ideally chartists use 200 day moving average as a long term mean, and as long as prices are above it, the bull market is said to be ON (in bull markets prices tend to correct to 200 day moving average and then bounce back). If prices fall below it and sustain below it, its the start of a bear market, and theoretically we can say that prices should keep falling and corrective rallies should be limited to the 200 day moving average. But this never happens we see prices cut through this average then bounce to new highs, at times we see prices cutting it through several times before emerging with same or reversed trend and at times there is literally no value given to this average.

One thing what we definitely can say by looking at price and 200 DMA is whether a bull or a bear market is extended. If we feel its extended, we can also start to have a feeling that there are chances of reversion to mean. Lets see the below chart, the upper chart shows percentage gap between price and 200 DMA of Nifty and the lower shows Nifty.

There are a few observation which I want to point out. Firstly with the exception of rally in first half of 1992, 60% has been the upper limit of extension of prices from 200dma. Its more occasionally under 40%. So we see how reverting to mean works in Nifty. In bear markets its more generally -20% with the exception of 2008 where prices fell below -40%.

Though we have not had any significant bear market apart from 2008, we see that in bull market 200dma is respected. I personally believe that we are in a larger bull market from 1998, and within that we are had 2 bear phases 2000-03 and 2008. See how well 200dma is protected from 1998-2000 rally (minor glitch in 2004), from 2003 to 2008 rally and from 2009 till now.

Another observation would be the fact that the bottoms that we have see till now are coinciding with the extremes, though tops are more generally seen after an extreme! (check the chart below). Which goes well with the saying that bottoms are events and tops are process. The last thing I will point is we are kind of in a Top formation pattern as per this chart. Anymore interesting observations are welcome!


Brahma said...

Hi Sir, Verymuch intrested and thought provking analysing which i found very rarely and bookmarked your blog. Very much though provoking and educating article. Sir whre can i find these charts

Tarique Anwar said...

i could not find these charts myself in the internet, so had to generate them at home!

Post a Comment