Is the stock market’s rapid decline the start of something much bigger?

by Troy

Is the stock market’s recent decline the start of a much bigger decline?

You’re probably wondering this question right now.

*Let’s analyze the stock market’s price action by objectively quantifying technical analysis. For the sake of reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

Such a rapid correction

The S&P 500 has fallen more than -9% from an all-time high in less than 30 days (using daily CLOSE $). This is quite a rapid “small correction”.

Such quick downwards reversals from all-time highs are uncommon. The last time this happened was January 2018.

Here are the historical cases in which the S&P fell more than -9% from an all-time high in less than 30 days.

As you can see, this usually led to a medium term rally in the next 3-6 months. The main exception was the 1929 stock market crash, but even that case saw the S&P rise more than 6% the next week.

What’s particularly interesting is that the last time we had 2 of these signals in less than 9 months was April 24, 2000.

1. We had a signal in February 2018 and now in October 2018.
2. There was a signal in August 1999 and again in April 2000.

While this sounds scary, it isn’t for medium term traders (we’re not buy and hold investors). The S&P still managed to rally for the next 4+ months before the wheels really came off the bull market.

The stock market’s short term is neither consistently bullish nor bearish

Our recent quantitative market studies have demonstrated that the stock market’s short term outlook (i.e. next 1-4 weeks) is mixed. These studies are neither decisively bullish nor bearish.

Here are 2 slightly short term bearish studies.

The S&P has closed below its 50 weekly moving average for the first time in 2 years (50 weekly = 250 daily). In other words, a long uptrend has ended.

Of course, this brings out all the permabears who are screaming “trendline is broken!!!!!” (never mind the fact that there are just as many false breakouts/breakdowns as there are successful ones).

Here’s what happens next to the S&P 500 when it closes below its 50 weekly moving average for the first time in 2 years. 

As you can see, the stock market tends to bounce 1 week, make a new low the 2nd week, and then rally higher.

We can get more samples by relaxing the study’s parameters.

Here’s what happens next to the S&P 500 when it closes below its 50 weekly moving average for the first time in 1 year.

Once again, you can see that the S&P has a slight tendency to go lower 2 weeks later.

Like the S&P, the Dow Jones Industrial Average has closed below its 50 weekly moving average for the first time in more than 2 years.

Here’s what happens next to the Dow when it closes below its 50 weekly moving average for the first time in 1 year.

You can see that the Dow has an even greater tendency to go lower over the next 2 weeks than the S&P 500. Perhaps this means that the Dow will underperform the S&P over the next few weeks.

Conclusion

Our discretionary outlook remains the same:

1. The current bull market will peak sometime in Q2 2019.
2. The medium term remains bullish (i.e. trend for the next 6-9 months). Volatility is extremely high right now. Since volatility is mean-reverting and moves in the opposite direction of the stock market, this is decisively medium term bullish.
3. The short term is a 50-50 bet right now. Moreover, the stock market will probably remain volatile in the short term (big up and down swings). 
4. When the stock market’s short term is unclear (as it is most of the time), focus on the medium term. Step back and look at the big picture. Don’t lose yourself in a sea of noise.

Our discretionary outlook is usually, but not always, a reflection of how we’re trading the markets right now. We trade based on our clear, quantitative trading models, such as the Medium-Long Term Model.