Stock market is making a sharp rally after a sharp drop. What's next?

Today’s big bounce has some people comparing the current market environment to October 2014, when the stock market dropped quickly and surged back to new all-time highs quickly.

The key point to remember is that:

  1. The medium term risk:reward is bullish
  2. The stock market usually (but not always) retests its lows.

Focus on the medium-long term.
With that being said, let’s get into quantifying and examining the stock market’s recent price action.

The stock market’s sharp reversal after a sharp drop

The stock market fell more than -2% for 2 consecutive days last week (Wednesday & Thursday), and then it rallied more than +2% today.
This is what happens next to the S&P 500 when it falls more than -2% for 2 consecutive days, then rises >2% in 1 day within the next 3 days.

As you can see, this tends to happen at the bottom of bear markets or big 14%+ declines. The only other time it happened after a smaller decline was this March 2018 at the stock market’s bottom.

You can see that even in this case, the S&P retested its lows before heading higher.

Another way to examine the stock market’s sharp reversal

The stock market fell more than -6% in the past 1 month after making a new all-time high (using daily CLOSE $), and today rallied more than 2%.

Here’s what happens next to the S&P 500 (historically) when it falls more than 6% from an all-time high in the past month, and then rallies >2% in 1 day.

Note that the S&P’s median drawdowns in the next 2-3 months is more than -3%, which supports the case for a retest.
However, what’s more interesting is that when this happens, the S&P goes up 3 months later 88% of the time.¬†Even in the worst case scenarios (2000 and 2007 tops), the stock market still bounced. Bear markets don’t go down in a straight line.

Oversold bounce

And lastly, the S&P’s short term momentum (RSI 5) has bounced back from being extremely oversold.

The S&P’s 5 day RSI went from being below 4 to above 40 in less than 1 week. Historically, it had a median drawdown over the next week of -1.2%

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6 comments add yours

  1. Troy, i am not sure i understand the drawdown concept. For ex, las chart on 16/10/2018 line, at 2 weeks return are +7.74% but 2 wks Max drawdown is 1.96%…what is the diff? Why important? Thanks.

    • “2 weeks later” tells you where the stock market closes in 10 days (i.e. 2 weeks).
      “Max drawdown” tells you what the biggest loss was during that same period.
      E.g. lets assume “2 weeks later” = 5%, and “max drawdown” = -3%
      It means that 10 days later, the market was 5% higher than where it is today. But in the meantime, the market fell -3% at one point
      If max drawdown is positive, then it means the market went straight up

  2. Slightly off topic question for you.
    When you exit in 2019 (or 2020) and the model predicts a bear market or significant crash, do you plan on shorting the market in some way?

    • Yes, but not immediately.
      The start of a bear market is very choppy, so shorting is really hard.
      I’m going to short in the middle of a bear market, but it drops in a straight line. The middle of a bear market is when the recession is at full force, which is really easy to identify

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