Friday, August 01, 2014

Historical Market Queries and What We Can Learn From Them

I've received several questions about the recent market selloff and whether we are near a bottom.  Above you can see my intermediate-term measure of market strength.  As a rule, it peaks before prices top out; bottoms before prices make their ultimate lows at major bottoms (high VIX regimes); and coincides with market bottoms at the end of corrections in bull markets (low VIX regimes).  The intermediate-term strength measure consists of a moving average of the number of SPX stocks making short-term, medium-term, and long-term new highs vs. new lows.  Major props to the Index Indicators site for carrying these data.   

The chart shows how we peaked in strength early in June and only recently crossed below the zero line.  Yesterday was an unusually weak day with respect to the intermediate-term strength measure.  Indeed, over the last 2000 trading days going back to 2006, we've only had 62 weaker readings.  Only 8 non-overlapping instances occurred during low VIX regimes (< 20); 5 of those 8 occasions were down after five trading sessions; 7 of the 8 were up 20 sessions later.  

For you market history buffs, the dates of recent weak market days similar to yesterday are:  2/27/07; 6/7/07; 6/3/11; 4/9/12; 11/8/12; 6/5/13; 1/24/14; and 4/11/14.  Note how these occurred in very different contexts--with very different longer-term outcomes.

I like such analyses, not because they predict the future, but because they illustrate the range of outcomes under similar market circumstances.  That can be a great check on our biases and bullish/bearish predilections.  Do the data suggest buying the weak day?  Not exactly.  Do they suggest selling?  Not really.  The modal course is lower in the short run followed by rally--but that can occur in topping markets, weak markets, and bull markets.  

The role of historical investigations is not to provide certainty, but to clarify--and encourage respect for--modal outcomes and the uncertainty surrounding those.  Once in a while those investigations confer a trading edge, but they invariably provide perspective and a check on overconfidence.

Further Reading:  Putting Markets in Historical Perspective