One More Perspective on Steep Declines

Note: I recently submitted an article to Trading Markets regarding the recent downward volatile trade. That should appear Monday AM. Also see the last couple of entries on this site for a perspective on the week to come. Finally, Sunday evening's Trader Performance blog on my personal site will offer some psychological insight as to how to utilize the historical analyses offered herein.

For my last analysis of Friday's sizable decline, I took a different approach. Going back to January, 2000 (N = 1518), I calculated the 200 day standard deviation of price changes and investigated what happens after the market moves more than 2 standard deviations lower in a single day. The beauty of this analysis is that it adjusts the investigation for changes in volatility over time, so that what is steep in a non-volatile market and in a volatile one is different.

I found 34 such occasions and looked at what happens in SPY afterward. Two days after the steep drop, the market was up 23 times, down 11 for an average gain of .77%. This is much stronger than the average two-day gain of .00% for the sample overall (759 up, 759 down). Steep drops tend to be followed by rebounds in the near term. Buying weakness the day after the steep drop and holding for strength the following day was a profitable strategy overall.

That having been said, the strategy was much less successful for much of 2001 and 2002 than for the rest of the sample. As we saw before, weakness in a bull market provides opportunity; in a bear market it often leads to a cascade of selling and a clustering of weak days. This clustering, such as we saw in July, 2002, is the reason why such weak market occasions must be followed by careful reading of subsequent real-time action. Although the odds are bullish following weak market days overall, when weakness does follow weakness, the downside can be substantial--especially given the enhanced volatility that such big down days engender.

Since the bull market started in 2003, we have had 7 instances of weak market days that have fallen more than two standard deviations. The market has been up 5 times, down twice, for an average two-day gain of .85%. Once again, the response of the market to the latest weakness will provide a piece of information regarding whether we continue in the bull mode.