Tuesday, February 27, 2007

Big Down Days: What Happens Next?

That seems to be the question everyone is asking following the meltdown on Tuesday. What we observed is a scenario in which everyone simultaneously runs for the exits. China's market was down over 9% in Shanghai prior to our open. The Yen soared to multiweek highs, a risk factor to the carry trade, as mentioned here a while back. As selling in the U.S. markets begat selling, we saw weeks' worth of profits eroded in a single session. Among money managers, who fight tooth and claw for each quarter's performance, such a drop was a major threat. Volume picked up dramatically, reflecting the exit of the institutional traders, and--with that--the decline accelerated, now wiping out months' worth of performance.

Such an occurrence is rare. I went back to 1990 (N = 4304 trading days) and could only find 25 occasions of a single day drop of 3% or more in the cash S&P 500 Index. What's even more rare is to have such a decline in the context of a bull market. How many times in the last 17+ years have we seen a 3+% decline in a market that had been up over the prior 20 and 60 days? It's only occurred three times out of all those trading days.

But shifts happen. And that, my friends, is why money management and risk control are all important. If you double your money, double it again, and then double it again, only to lose 90% in the next debacle, you wind up down 20% on your initial capital, needing a 25% gain just to return to where you were at the start.

So what happens after big down days? Let's start with the 25 occasions in which we've dropped 3% or more in a single day. At just about every time frame from one to twenty days out, returns following such a large single-day drop are quite bullish. One day later, the S&P averaged a gain of .47% (17 up, 8 down), much stronger than the average single day gain for the rest of the sample of .03% (2256 up, 2023 down). Twenty days later, the S&P was up by an average of a whopping 4.47% (20 up, 5 down), again much stronger than the average 20-day gain of .73% for the remainder of the sample (2641 up, 1638 down). In all, large down days have tended to represent buying opportunities since 1990.

Those findings may be a bit deceptive, however, because--of those 25 large down days--15 occurred in the context of a market that had *already fallen* 3% or more over the past 20 sessions. In other words, large down days have tended to occur toward the end of market downmoves--as a kind of washout. We don't typically see large down days following intermediate term strength, as noted above.

I relaxed my criteria a bit and found six occasions in which the market had not been down more than 2% on a 20 and 60 day basis prior to the large down day. All six occasions were up the next day, and all were up over the following 20 sessions. Indeed, the average gain over the next 20 trading days was an impressive 3.89%.

In short, big down days have tended to represent panic and, even when they've occurred in relatively strong markets, they have tended to occur nearer to market bottoms than tops. On average, traders have made money by buying into such panicky markets. While the current volatility may be more than many traders wish to tolerate, at the very least the pattern of superior returns following panicky declines should offer caution to those tempted to arrive late to the bear's party.