Friday, January 17, 2020

Is A Very Strong Market "Due For A Correction"?

I've been hearing a lot from people who loudly assert that a strong stock market such as we've recently witnessed is "due for a correction".  Those making the assertion have several things in common:  1) a strong conviction that a bearish move is on the horizon; 2) a total absence of any statistical evidence supporting their view; and 3) dramatic underperformance during the recent market period.  

So let's look at a little bit of evidence.  (Eye-opening evidence, by the way, was published overnight by Market Tells, SentimenTrader, and Quantifiable Edges).

We'll go back to 2005 and identify occasions in which more than 80% of stocks in the SPX have been trading above their 3, 5, and 10-day moving averages and in which more than 80% have been trading above their 100-day moving averages.  (Data from the excellent Index Indicators site).  So we're looking at short-term strength in a longer-term strong market.

There have been only 39 such daily occasions out of over 3300 trading days.  That alone tells you that such broad strength is rare, even in a market that has risen over the lookback period.  Out of the 39 occasions, 22 occurred in 2009 and early 2010.  Note that this was a new bull market period following an important bear market.  During such periods, as I noted back in March, we tend to see momentum conditions.  It's easier to see that we have emerged from a bear market when we look at weekly price charts for small caps and overseas stocks, both of which declined from early 2018 through well into 2019.  

After the strength noted above, in 33 of the 39 occasions we posted a lower daily close within the next three trading days.  So, yes, a pause in the rise after unusual strength has been normal.  However, if we look 20 days out, the average market gain has been +1.43% versus an average gain of +.61% for the rest of the sample.  Over that next 20-day period, 27 occasions were up and 12 down.

History is not guaranteed to repeat itself, but formulating strong views in the absence of any knowledge of history is not trading: It is malpractice.  History provides a rich source of hypotheses and an understanding of market flows can tell us if history is, indeed, playing out.  Markets dance to the rhythms of momentum and value; edges occur because so many participants can't hear the music.

Further Reading: