Tuesday, January 22, 2008

Large Downside Opening Gaps: A Look at Fear and Uncertainty in the Stock Market

As markets continue their declines this morning, traffic on this blog is running about 60% above normal--something we don't see in rising, low VIX markets. As I've mentioned in the past, one coping mechanism for uncertainty and fear is seeking information, so blog traffic becomes a kind of sentiment measure. We are seeing elevations of traffic comparable to those at the market drops of March, August, and November of 2007, for example.

The fear and uncertainty are understandable: Opening drops of over 3% are quite rare in market history. I looked at first-hour changes in the Dow (change from the prior day's close to the end of the first hour of the next day) going back to 1960 and could only find 7 drops of 3% or more. Five of these occurred in the October, 1987 debacle, one following the 9/11/01 event, and one in October, 1991. Four of the 7 opening declines dropped further from the end of the first hour to the close. More broadly, we've seen 46 declines of over 2% from the prior close to the end of the first hour of trading since 1960; 22 of those traded lower from the first hour to the close.

Yet, once again, when we look at the historical periods of those historic opening declines, some dates stand out: October, 1987; September-November, 1974; October and December, 1978; October, 1982; August, 1990; April, 1994; August/September, 1998; September, 2001; September, 2002; and March, 2003. All in all, not a bad list of times when it paid to be a buyer over the longer haul.

The moral of the story is that, in the short run, panicky markets can decline further. Investors with longer time horizons, however, have generally done well by putting money to work when panic fills the air.


Historic Declines in Stocks


Elliot said...

Maybe we go down more, but this week we saw the VIX open with a dramatic gap up, putting it over the weekly breakout threshold early monday morning.. In my experience, weekly breakouts usually work better when they play out in an orderly fashion towards the end of the week. There is plenty of time this week for the VIX to fall below the breakout pivot, which is action associated with tops and reversals.

Good day!

Investment Guru said...

Hi Brett,

Here's wishing you a prosperous new year!

I agree with you with regards to short term sentiment. But Post 9/11 time wasn't exactly a great time to start investing as we declined for over a year after that. Given that, this period needn't necessarily be the best time to invest. We will definitely rebound because sentiment is so negative, but we could retest or possibly go lower than the lows we've created in Jan.

Just my $0.02 :)


Brett Steenbarger, Ph.D. said...

Hi Sajal,

Good point; there are definitely risks of drawdown when buying into such weakness--