Thursday, October 11, 2018

What Happens After A Huge Down Day?

Well, I had a record number of phone calls and emails yesterday and you can guess why.  The yellow caution signal that we discussed on September 24th proved to be a worthy alert.  Yesterday the stock market dropped around 4% on very elevated volume, closing at its lows for the day.  I went back to 1993 in SPY and learned a few interesting things:

1)  This daily move down was more than 5 standard deviations from the average move, using the last 100 trading days as a reference point.

2)  Downward moves of over 4 standard deviations have occurred only 15 times since 1993.  So, in over 6000 days of data, this has occurred less than .25% of the time.  It's a truly rare occurrence.

3)  Occasions when the 4+ standard deviation moves have occurred include the following dates.  Note the prominence of bear market periods and significant market corrections.  Note also that one such occurrence does not prevent the possibility of another occurrence shortly after, as in 2015 and 2018.  We also saw multiple large down days in 1994, 1998, and 2008, though not at 4+ SD.  In other words, we cannot count on "one and done"; such outlier events tend to cluster:


4)  One day, five days, and 20 days later, the market was up 11 times and down 4.  Over the course of the next 20 days, the market made a lower close on 9 of the 15 occasions.  On the occasions where the market made lower closes five days later, all four declines were in excess of 2%.  On 10 of the 15 occasions, the market moved more than 2% over the next 10 trading days.  Volatility continued to be the norm.

So what can we take away?

A)  We are in a historically rare event.  Casually applying normal rules and "setups" to the current situation can be hazardous to your wealth.

B)  A bounce from the big down day is the most common scenario.  Twelve of the 15 occurrences posted a higher close within the next five trading days.  That being said, the majority of instances also posted lower closes over a 20 day horizon.  V bottoms have been the exception.

C)  Volatility continues over the next 20-day period, with moves greater than 2%--up or down--occurring in all but two of the instances over the next ten trading days.  

D)  The presence of one rare drop does not preclude others from occurring and indeed there is evidence of clustering during bear periods.  Failure to sustain rallies after the big drop should be viewed with caution.  Significant additional large drops occurred in 2008, 2015, and 2018, for example.

Psychologically my takeaway is that investors should have a long-term view of opportunity--on a long time frame these were good buying opportunities--but on a short time frame a degree of hedging is prudent.  Shorter-term traders should view a failure to sustain bounces as possible occasions for further large declines.  Open-mindedness is key.