A historical study of market-drops like what we saw on Monday suggests you want to stay invested right now
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***Monday saw the S&P suffer its biggest drop in four months
Meanwhile, the Dow fell more than 600 points …
And the NASDAQ saw its biggest decline of the year.
Many popular, widely-held stocks fell even more. For instance, Boeing and Caterpillar fell nearly 5%. Apple fell nearly 6%.
Across the board, investors fled to safety, pushing Treasury yields to their lowest level since late March.
A day like Monday makes even the most emotionally-sturdy investor feel a bit nervous, wondering what’s around the corner. Is this the beginning of a broader sell-off, or is this simply a normal breather in an ongoing bull market?
***One way to answer this question is by studying similar market moves in the past
This is the approach preferred by quantitative investors.
The idea is simple — let’s look at real, historical market data, identifying pattern and trends, and let’s use that data as loose proxies for what the markets might experience again. After all, what drives the markets are human buying/selling decisions — and frankly, humans tend to make the same choices time-and-time again … which often results in market patterns that we can study for an edge.
John Jagerson is the editor of Strategic Trader. He also happens to be one of the smartest quantitative investors in the business. That’s why I reached out to him after Monday’s drop. I wanted to put the move into perspective. As importantly, I wanted to get John’s thoughts on what it might mean for the market over the coming months.
Let’s jump to it …
Jeff: John, let’s start with some context. How significant was Monday’s drop?
John: Well, the S&P 500 fell 2.41% for the worst one-day loss since January 3rd, 2019. Although bull markets regularly experience interruptions and big down-days, it is still frustrating when it happens.
The important question is whether a big daily loss like this tells us anything about the next 30-days. Is this a good buying opportunity or should traders hang back and wait for the market to consolidate at support?
Jeff: You just asked my follow-up question. What’s the answer?
John: Over the last 10-years, there have been 72 days where the market lost more than -2% and those losses have been followed by a positive return over the next 30-day period 70% of the time.
The average profit for the month following a big day to the downside is +2.7%, which may not sound like much, but helps put recent market volatility in perspective.
Jeff: So, those numbers are based on a big percentage-drop. But did you do any research based on the markets falling to a key support level and holding like they did on Monday?
(NOTE FOR READERS: On Monday, the S&P held a key pivot level on a head-and-shoulders pattern as you can see in the chart below.)
John: I did. And if we only look at those instances where the market has pulled back to an important pivot or support level, then the average returns are much larger.
For example, the second time the S&P 500 dropped to support at 1,877 in September 2015, the index rallied +10% in 30-days. In June of 2016, the S&P 500 dropped to its pivot level of 2,040 and subsequently returned +6.6% over the next month.
Over the last 10-years, a big daily-loss that moved the S&P 500 to a previous support level has signaled a positive return of +5% or more over the next 30-days nearly 90% of the time.
Jeff: So, let’s forget the numbers. Just translate everything for us. What’s the takeaway?
John: The bottom line is that bull markets tend to recover quickly after a big down day if investors are willing to give the market a month to shake out the “weak hands” and reward investors able to take calculated risks.
Jeff: You’re still in the market then?
John: Yes. I think avoiding the market at this point would be a big mistake. Even the more moderate historical statistics indicate a high likelihood for a positive return over the next few weeks — especially among stocks with positive growth characteristics.
Jeff: But how does the risk of China and the trade war play into this? Isn’t that a reason to sit on the sidelines?
John: One of the underlying premises of technical analysis is that the estimated impact of macro factors like tariffs are already priced into the market. So, I have to conclude that investors aren’t waiting to react to tariffs but have already done so.
Of course, it is unknown whether the “market’s” estimates of the tariff-damage have been correctly priced. Since we can’t predict the future, this leaves a material amount of uncertainty hanging over the market, which can account for the infrequent, but large, negative returns we see from time to time.
Jeff: So, you’re not worried that the idea of “this time it’s different” could apply here due to the trade war?
John: Well, was it “different” for the taper tantrum of 2013, the fiscal cliff of 2012, or the collapse of the oil market in 2015? I always tell traders at times like this to remember that prior pivots were accompanied by very similar exogenous risks.
Jeff: Everything you’re saying seems cautiously bullish. Am I interpreting that correctly?
John: Yes. Right now, we remain bullish on the market, but also believe that risk is elevated compared to 2017 or 2013 or similar years when there were fewer issues hanging over the market.
This is why we are still looking for upside potential but have been trading much more cautiously than we were in the first quarter this year.
What we want is to avoid is falling into the trap of overpricing the negative effect of factors like tariffs until we have more concrete data.
Jeff: So, you’re trying to avoid becoming too conservative despite the scary headlines. I assume that’s because you feel the market’s trend is still “up” and you don’t want to be on the sidelines?
John: Correct. Essentially, we are trading off the risk that we might be too bullish for the much more likely risk that we will miss opportunities to profit if we overestimate the negatives hanging over the market.
I would rather be wrong infrequently, like the first and fourth quarter of 2018, etc. and manage my way through that kind of volatility than too cautious and miss the big trends.
Jeff: Let’s finish by trying to make this as helpful and actionable as possible for our readers. Factoring in China, the length of this current bull market, yet also the various tailwinds supporting it, what’s your final takeaway for how our readers should view the market right now?
John: The primary trend of the market is still positive. Earnings growth is slightly negative, which is worrisome, but much of that is the result of the tax cut effects from the comparable quarter last year.
I am not a “perma-bull” or anything, but I would want to see more concrete evidence that the bull market is ending before shifting our bias from cautiously bullish to bearish.
Bottom line, volatility like this will always make precise timing difficult, but the outlook for the next month indicates this is a good opportunity to buy stocks in positive sectors, like tech or retail. Alternatively, investors should focus on building a long position in ETFs that track large-cap indexes.
Jeff: Thanks, John.
John: Thank you.
***As of Tuesday’s close, the S&P rose nearly 1%, recovering almost a third of its Monday losses, so it appears the rally suggested by John’s historical market study may have already begun
And as I write Wednesday morning, markets are pushing higher again on positive trade war news that Trump may delay auto tariffs. We’ll continue to keep you up to speed. And once again, I hope you’ll join us Thursday for our free, live market event. Click here to register.
Have a good evening,
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