Get out your No. 2 pencils
10/19/18

●S&P 500 turned lower after Tuesday’s big rally

●Similar past episodes hint at possible test of last week’s low


 

The S&P 500’s (SPX) tepid performance Wednesday and bearish turn yesterday may have disappointed bulls who were still buzzing over Tuesday’s huge rally, which was only the second 2%-plus SPX daily gain since November 2016. Coming just two days after the October 10-11 slide, it offered skittish investors some hope that the bears were sauntering back into their cages.

S&P 500 (SPX), 8/28/18–3/14/16. S&P 500 (SPX) price chart. Sell-off and bounce

Source: OptionsHouse

But the previous instance, the 2.7% rally on March 26, hinted at what can sometimes happen after the market bounces big after a nasty drop: The SPX fell 1.7% the next day, and ultimately (on April 2) tested the previous sell-off low before getting into bullish gear. (The market does seem to like its tests.)

Although one roughly comparable market episode doesn’t mean much, if you look at what has happened after the all other times the SPX has done something similar, there’s some evidence the market is behaving in fairly typical fashion and could be setting up to test the October 11 low.

After Tuesday’s 2.15% rally, the SPX essentially closed flat (-0.71 points) before turning decisively lower yesterday, closing below both Tuesday's and Wednesday's closing prices. If we look at what’s happened after all the other times over the past 50 years that the SPX has rallied 2-4% and two days later had a day (like today) that closed below the previous two lows, we find:

●After a one- to two-day bounce, the SPX on average posted a net decline over the next four to five days.

●After six days, for example, the SPX was lower 54% of the time and had an average loss of -0.24%.1

As always, it’s important to remember these are "composite" stats—what you get when you mash together a bunch of examples, some of which were followed by down moves, others by up moves, big, small, and in-between. (March 26-28 fit this pattern, for example.) After all, there were 95 previous examples of this price pattern, which means the SPX was higher six days after 44 of them (46%). But the major takeaway is that several days after the pattern, the SPX was lower more often than it was higher, which is nothing to sneeze at since the index has historically gained ground in 56% of all six-day periods over the past half century.

What makes this worth looking at is how it may fit into what the market is doing right now—bouncing for a few days and then retreating after experiencing a sharp pullback. Would a test of that low be such a surprise during a classically volatile October?

S&P 500 (SPX), 12/11/15–3/14/16. S&P 500 (SPX) price chart. Bounce and test

Source: OptionsHouse

Again, it’s just one example, but the pattern from early 2016 offers a good illustration of these market dynamics (chart above). After selling off to a nearly 14-month low on January 20, the SPX bounced and inched higher for a few days before putting up a 2.5% rally on January 20. Two days later, though, it turned lower and closed below the previous two lows. After a brief bounce, the SPX turned lower again, ultimately testing the January low on February 11, which turned out to be a major swing low.

This time may or may not unfold similarly, but if and when a test occurs, many traders will likely be closely watching the Cboe Volatility Index (VIX) to see how it compares to its level from October 11.

The market rarely repeats itself exactly, but it often rhymes.

Today’s numbers (all times ET): Existing Home Sales (10 a.m.).

 

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1 Supporting document available upon request.