The stock market tanked last week. In our weekend market outlook, we said that:
- The stock market’s medium term is bullish.
- The stock market’s short term leans bearish. Expect a quick bounce and then a retest or marginal new low.
Here’s more proof that the stock market will probably retest and make a lower low before heading higher.
The S&P 500’s recent price action is curious. It fell more than -2% for 2 days in a row, and then swung in a narrower range over the next 2 days (i.e. 2 inside days).
Conventional technical analysis sees this as a trend continuation pattern. Is it?
Here’s what happens next to the S&P 500 (historically) when it falls more than -2% for 2 days in a row, and then has 2 “inside days”.
As you can see, this is rare, and comes close to marking some long term bottoms. However, some more short term weakness does usually ensue.
To get more cases, we can relax the parameters and see what happens next to the S&P when it falls more than -2% (for 1 day), and then has 2 inside days.
As you can see, the S&P tends to fall over the next 2 weeks, with a median max drawdown of almost -3%.
With that being said, the stock market’s short term weakness is likely to be short-lived in terms of time.
The S&P 500 has been flirting with its 200 daily moving average recently. It fell below the 200 dma last Thursday, went above the 200 dma last Friday, and then fell below the 200 dma again today.
Historically, the stock market tends to go up in the next 1-3 months. The median 3 month forward return is 6.8%, while the median max drawdown for that same period is -1.3%.
That’s a 1:5 risk:reward ratio.
It appears that these indecisive breakdowns below the 200 dma are more bullish than decisive breakdowns.
The stock market’s recent decline has been rather fast. It fell more than 7.5% in less than 1 month from a 3 year high.
Historically, this led to a bounce over the next month.
You can see that even in the WORST CASE scenario (2007 and 2000), the stock market still went up. Bear markets don’t go down in a straight line.
And lastly, as of last week, the S&P fell 3 weeks in a row. This happened 166 times from 1950 – present. 70% of these cases saw the S&P make a lower LOW the next week. The median drawdown was -0.6%
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*Remember to focus on risk:reward. While the market does have some short term downside risk, the medium term risk:reward favors the bulls. The stock market usually bounces and retests its lows after a crash like last week’s. The keyword is usually, but not always. Sometimes the market goes straight up (e.g. October 2014).