Friday, August 10, 2007

Short-Term Waterfall Declines in the Stock Market: What Happens Next?

Well, I was all excited and went to show Mali the post about her, but she'd hear none of it. "The market was down big overnight yesterday," she exclaimed. "Then it was down big during the day session. Now it's down big going into today's open. Tell the people what happens in the market when this has occurred in the past!"

Mali's a very practical cat.

Anyway, I went back to 1996 (N = 2891 trading days) and found only four occasions in which we had a prior overnight session down by 1% or more followed by a day session down by 1% or more and a current overnight session down by 1% or more. Interestingly, these short-term waterfall declines tended to occur at key junctures near intermediate lows in bear markets: 9/21/01 (after the 9/11 incident); 10/28/97; 4/17/2000; and 10/1/98. Three of the four occasions rose very sharply during the subsequent day session (over 3%) after dipping very little after the open. The one occasion that was down during the day session (by a little over 1%), recovered to a gain the following day.

I relaxed the criteria to look for occasions in which the prior overnight session, prior day session, and most recent overnight session were each down .50% or more (N = 16). When we look two days out (to the close of the *following* day's trade), the market was up 12 times, down 4 for an average gain of 2.20%--much stronger than the average gain of .01% for the market overall during the remainder of the sample.

Once again, it was when the downside was contained during the day session following the short-term waterfall that near-term returns were particularly outstanding. It appears that these waterfalls have the potential for triggering considerable short covering when they dry up.