Friday, October 12, 2018

Lessons We Can Take Away From Broadly Oversold Markets

And the trick, of course, is getting cut the right way.  An uncut diamond isn't worth much, and a diamond cut the wrong way is too flawed to be worth anything.  When we take losses the right way and learn from those, that's when we develop the facets that give us value as traders.

One of the bad cuts I see people taking in the recent equity markets is failing to adapt to new, volatile market conditions.  Buy the dip at VIX of 12 is quite different from the same strategy at VIX of 24.  When a market becomes more volatile, we trade more volume per unit of time.  Moves that might have unfolded in hours now occur in a few minutes.  That has relevance for how you size positions and how much heat you can take on ideas that ultimately work out.

I looked at the overbought/oversold statistics from Index Indicators and found something outstanding.  Fewer than 5% of stocks in the SPX are trading above their 3, 5, 10, and 20-day moving averages.  In other words, not only are we quite oversold; we are very broadly oversold.  Essentially everything has gone down.

So what has happened historically after such broadly oversold occasions?

Since 2006, when I began my database, we have only had 15 other such days.  That means that broadly oversold markets only occur less than half a percent of the time.  As we saw in the last post, this means that the current market conditions are historically rare.  Below we can see the dates of occurrence in chronological order:


We can see right away two things:

1)  These rare occasions can "clump".  When we see one, it's not unusual for others to follow.  This is also something we saw in the last post.  A very oversold market can stay oversold for a period and indeed become more weak.

2)  These occasions have occurred during markets we have recognized as meaningful corrective periods or as bear markets.  These occasions have also been accompanied by significant volatility.  The median VIX for the 15 occurrences has been almost 41.  The median VIX for the rest of the sample is a little over 16.

And what have been the forward paths for these broadly oversold markets?

Bounces have been the norm, but it's not always a one-way path.  The next day has been 9 up, 6 down.  Two days later has been 12 up, 3 down.  Five days later has been 12 up, 3 down.  That being said, ten trading days later we see 8 up, 7 down.  Ten of the 15 occasions have posted a lower daily close within a ten trading day period.  Two-sided markets over the next two weeks are not unusual.

Forward volatility is expectable.  Thirteen of the 15 occasions moved more than 2% from close to close over the next two trading sessions.  Nine of the occasions moved more than 4% up or down over a next five-day period.  Very large moves are not uncommon.  During 2008, we saw near-term closes up 9% or more and down 9% or more.  After the 2011 occurrences, we saw moves up and down exceeding 5%.

There has been opportunity longer-term.  The longer-term investor recognizes that broadly oversold markets are taking down high quality, growth companies along with less stellar firms.  This can create unusual value for individual stocks and also for the market. With the exception of the 2008 occurrences--a protracted bear market--we were meaningfully higher in SPX one year after the broad selling periods.  If we believe this to not be a recessionary period with major economic dislocations, the drop can be a great opportunity to buy stocks for longer-term holding periods.  

So it's back to the theme of getting cut the right ways.  When market participants puke, it's common to see favorable forward returns, but not without volatility and retracements.  Shorter-term traders can take each day as it comes, knowing there will be meaningful movement to capture.  Longer-term investors can identify stocks worth snapping up at bargains, but also create market hedges (and size appropriately) to weather the forward volatility.

Knowing historical patterns is a great way to prepare oneself for forward price paths.

Further Reading: