Large 5-day declines and subsequent market performance

Last week, we discussed what happens when after a period of low Volatility that is hit with a sudden market break. The short version is "Volatility increases."

The immediate response — buy the dip — was the knee jerk response. That is at its essence a single variable analysis (If X, then Y). The more elements we control for, the more accurate and predictive any analysis is likely to be. Let’s consider both the context of the drop, and market internals.

Mike Panzner played with the data a bit, looking at rolling 5 day periods where there have been SPX declines of 5% or more, relative to recent highs. (Talk about great timing; His book Financial Armageddon was released on March 1, 2007 — the day after the big crack — its now #52 on Amazon).

Here’s Mike’s analysis:

Over the past 30 years, there have been 99 5-day declines of 5% or more in the S&P 500, out of a total of 7,563 5-trading-session spans. In other words, they are relatively rare, occurring only 1.31% of the time.

Yet, big downside runs don’t necessarily represent the no-brainer buying opportunities that some bulls claim.

If, for example, you split the list into 5-day declines that occurred when the last day of the span was within 10% of a 52-week high, as opposed to when it was not, there is a divergence in the subsequent one-month returns.

At those times when 5-day decline have occurred near market peaks, the median performance 20 trading sessions later has been 1.60%, which is only marginally higher than the median 20-day subsequent return for all trading sessions over the three decades. Median performance for all days (T+20 trading days) is  0.99%.

However, when that is not the case — when the market has already been under pressure — the median subsequent 20-day return has been 4.53%, which represents  a substantial measure of outperformance.

In general, then, when the market gets pounded for 5 days, the odds that you can make money from the long side over the course of the following month appear to be substantially higher when the market has already been suffering beforehand.

Consequently, those who argue that the 5.19% 5-day slide in the S&P 500 (through  yesterday), which occurred not long after the market hit a new 52-week high, is  a major buying opportunity may be in for some disappointment.

In other words, the relative market period preceding the break — are we in Bull market, near a top, or at the end of a long selloff — has significance to subsequent market action post break. By adding a 2nd variable (5% five day drops relative to recent highs) should provide more accurate guidance than merely controlling for a single variable ("Buy all 5% drops").

click for larger graph

5day20day

Courtesy Michael Panzner

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Also worth adding into the equation are market internals. Birinyi Associates did just that, looking at subsequent returns after the S&P500 reached extreme levels. They found that "in each period shown, if the market showed losses after the first week, it remained in the red for the two week and one month periods as well."

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click for larger graphs

Sp_500_with_5day_ad_line_1

Courtesy of Birinyi Associates

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Note that in the following table, whether we are in a Bull or Bear trends does have a high degree of correlation to subsequent outcomes.

Consider: From 1997-99, most dip buying following A/D extremes was rewarded; Doing the same thing during the bear market — in this case, 2001 thru January 2003 — was not. Since then, From September 2003 to October 2005 was quickly profitible; May 2006 was not. 

Table_spx_1

Courtesy of Birinyi Associates

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  1. winjr commented on Mar 7

    Interesting stuff, Barry. Thanks!

  2. Dan commented on Mar 7

    With US futures trading in negative territory, European stocks are modestly to the upside this morning even as German manufacturing orders fell 1% in Jan, marked by a drop in foreign demand. The Nikkei though is trading to the downside this morning as the Yen is rallying a bit. Interestingly, for those calling for an end to the “correction,” following yesterday’s rally, the S&P is now only 4.5% off its highs and was down less than 6%

  3. Curt commented on Mar 7

    Hi Barry,

    The biggest frustration with the talking heads, economists, experts put in front of a camera, even fund heads is the lack of even general knowledge of charting, TA and elliott wave!?! The two TA / Elliot services that I subscribe to (neither are the elliot org which I’m subscribing to soon) chart March 12 or there abouts to be the big down wave start.

    Sunday +/- is a solar eclispe and big crashes have been near eclipses. BTW a lunar eclipse was last Sat. Hmmm….

    I find more sense on the contrairian econ blogs than the true traders blogs / boards.

    What’s with the total false good news view of common America?? Why can’t economists/traders see that consumerism and debt has hollowed out any tolerance to financial stress events in all but the highest income classes?

    Good luck to everyone. Curt

  4. sam commented on Mar 7

    curt, i fear eclispes.
    i fear year of the pig even more.
    i am buying puts & puts & puts.
    got cohones?

  5. Richard commented on Mar 7

    thanks barry. the fundamentals have been weakening for quite some time even as the market made new highs. buying at this stage on a sharp correction just doesn’t feel right and the data you present supports this.

  6. DD commented on Mar 7

    what was the avg. 12 month return of the Panzner study as opposed to shorter term 20 day returns…or even 6 months for that matter…

    You like Pazner’s stuff more then Addison?

  7. DD commented on Mar 7

    ohh and btw…Ann Coulter is a MAN! you ever see that huge adam’s apple…geez…cant fool me Ann…not falling or that crying game shit again…

  8. Loren commented on Mar 7

    You know what I see in that chart? Regardless of what the outcome was over the next two weeks or a month, buying those dips wasn’t such a bad long term strategy. Certainly better than buying the highs.

  9. Fred commented on Mar 7

    Good balanced piece Barry…thanks.

    Birinyi also did a study that mentioned that this dramatic type of pullback has never happened so close to a top, when in a bear market. So IF this is a bear market, “it’s different this time”, fwiw.

  10. Guy Lerner commented on Mar 7

    I posted this the other day but likely more appropriate here as we are talking about buying opportunities after a down draft.

    “Buying opportunity of a lifetime? I read one analyst’s comments that 6 months following a 3% one day correction the Dow is higher over 75% of the time. That is actually a true statement. But let’s look a little more closely at such a strategy utilizing the last 40 years of Dow Industrials price data.

    If you bought the Dow the day after a 3% correction and sold in 125 trading days later (or six months), such a strategy actually generated 5081 Dow points out of a possible 11000. This is not a bad strategy especially when you consider you were only in the market 22% of the time. On the surface you made almost 50% of buy and hold, but you were in the market only 22% of the time.

    What the analyst forgot to mention is the drawdown characteristics of such a strategy. There were 18 trades in the last 40 years from this strategy. 10 of these trades had individual draw downs that were greater than 9%. In other words, you bought Dow the day after a 3% down day, and then you had to lose at least 6% or more of your money before the market turned around.

    In my opinion the real question with any strategy isn’t how much money you make but how you make your money. Yes, this strategy makes money, but it does so in a way that I think would not be tolerated by most investors.

    So being down 3% in a day does not identify a market bottom. Continued losses are just as likely as continued gains.”

    We can mush mash the data any way we want but would agree that there is a big difference between down drafts at market tops versus market bottoms.

  11. eightnine2718281828mu5 commented on Mar 7

    OT, but related…

    Anyone notice that when Greenspan made his comment that the economy looks good housing looks like it’s bottoming, no one complained?

    But a few weeks later, when he says there’s a 30% chance of recession, a cry went up for the old man to keep his trap shut and give Ben some breathing room?

    Funny how that works.

  12. greg0658 commented on Mar 7

    “Why can’t economists/traders see that consumerism and debt has hollowed out any tolerance to financial stress events in all but the highest income classes?” (Curt above)

    IMO the whales do. Get ready for auctions on the streets.

    I’m really hoping for a intelligently designed symphony instead of this game of football we play.

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