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S&P 500 vs R2K

May 26, 2011

Yesterday, we noticed that the Russell 2000 ETF had a strong up day while the S&P 500 barely scratched out a gain. Recently we’ve been noticing that the small cap index might be leading the overall market, so we ran a basic test: whenever the IWM closes up over 1% while the SPY closes up less than .5% (or down), buy the IWM at the close and hold for the next 2 days.

Going back to January of 2009, we found 19 occurrences. The average return of the Russ was a loss of 1.2% with a Standard Deviation of 3%. The results are not all that significant statistically, but the tendency seems towards mean reversion.

But then we looked at the equity curve of this trade over the years:

As you can see, for a while the system was great for catching breakouts, before it became great for mean reversion. To us, that means there is really nothing here and  we can’t say we know anything by observing how the R2k behaves compared to the S&P on any given day. But this is a great example of how even quantitative testing is as much art as it is science. How does one treat a pattern that flip flops? How far back do you test? Is it curve fitting if you add another variable to try to smooth it out?

These are all important questions for any quant to ask, and the answer is as much about personal style and preference as it is about math and statistics.

Categories: stocks
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