Too Early To Tell What Bounce Means

After seeing the S&P 500 shed 108 points from its recent peak to Monday's close, dip buyers jumped back into the water Tuesday. The 14 point gain Tuesday afternoon recaptured only 13% of the 108 points, meaning it is too early to say what the gains mean to investors with longer time horizons. From Reuters:

U.S. stocks bounced back on Tuesday, underpinned by sturdy corporate results. Monday's sharp decline, on the back of weaker-than-expected U.S. data, concerns over growth in China and the outlook for some emerging economies, opened the door for traders looking for bargains. Consumer and financial stocks were leading the gains on the S&P 500.

We Can't Fall Much Further, Can We?

The tone on Twitter seems to favor the theory of "we have dropped 108 S&P 500 points in the last three weeks....it must be time to buy...right?" That may or may not be the case; only time will tell, but before we jump blindly back into the equity lake it is prudent to understand how long corrections can last. One of the best ways to test your investing contingency plans is to examine extreme cases in history, which is what we will do in this article. The S&P 500 recently broke below its relatively-flat 50-day moving average, which tells us the intermediate-term trend is in doubt. As of February 4, the S&P 500 had traded below the 50-day for eight sessions.

Charts Help Monitor Interpretation Of Fundamentals

Our analysis below uses charts. Does that mean the fundamentals do not matter? Absolutely not. The interpretation and perception of present day economic activity, earnings, Fed policy, etc. are what drive the charts and determine asset prices. The charts help us monitor the present day "read" on all the fundamental data, which aligns with the expression the fundamentals are captured in the charts. Fundamentals and people determine asset prices; not charts. Charts are a monitoring mechanism.

Concerns About 2014 Fundamentals

The weakness showing up on the 2014 charts is the result of numerous economic concerns, including weakness in emerging market economies. From Bloomberg:

Emerging-market stocks fell, extending the worst start to a year on record, on concern the global economic recovery will wane. Lenovo Group Ltd. drove a selloff in technology companies after five analysts downgrades. About $2.9 trillion has been erased from equities worldwide this year after manufacturing gauges in the U.S. and China, the world's biggest economies, signaled a slowdown at a time when the Federal Reserve is cutting stimulus. All 10 groups in the benchmark measure for emerging-market stocks retreated today, led by technology, industrial and consumer shares.

Study Looked At Worst Cases

Our study began in 1987 and looked for similar violations of a flattish 50-day moving average. We were interested in how much further and longer stocks could drop from a similar point to February 4, 2014 (S&P broke 50-day eight trading days ago). The blue arrow below denotes a point similar to February 4, 2014 from two perspectives: (1) the S&P 500 violated a flattish 50-day, and (2) we are looking at eight trading sessions after the break. We are not comparing the economy, Fed policy, interest rates, or anything else in 1987 to 2014 (so please hold your tweets and emails about how today is different).

How Much Further And How Much Longer?

We calculated two things: (1) the ADDITIONAL loss from the blue arrow to the green arrow, and (2) the number of calendar days between the blue arrow and green arrow. The rationale is the present day market could be where the blue arrows are in the charts above and below, which allows us to answer the question:

How much further could the S&P 500 fall from its February 4, 2014 level based on the worst outcomes under similar circumstances between 1987 and 2014?

We Are Not Forecasting Any Outcome

The purpose here is not to predict that stocks will fall further, but rather to point out that they could based on numerous periods in recent history.

The Results Say Keep An Open Mind

We found nineteen cases (1987-2014) where stocks corrected for a relatively long period of time after slashing through a flat 50-day in a similar manner to what we just experienced in 2014. In these nineteen cases, the average ADDITIONAL loss was 12.31% and the average number of calendar days before a stable bottom was reached was 76. Therefore, if the S&P 500 followed this average path from February 4 levels, it would not bottom until April 21, 2014 and would do so at a level of 1,538.

Removing The Bear Market Cases

Given the market's profile in late 2013, it is not out of line to say the current odds favor a correction in 2014, rather than a shift into a full bore bear market. If we remove the two bear market cases (2000, 2007-2008) from the original set of nineteen, the average loss drops from 12.31% to 9.28% and the number of calendar days drops from 76 to 62. Therefore, even under a bull market/correction scenario, history tells us to keep an open mind about the possibility of further declines in stocks.

Are There Quick Recovery Examples In History?

Yes, you can find numerous instances where stocks rally sharply after breaking through a relatively flat 50-day moving average. As we noted at the top, we are interested in extreme cases in order to gain an appreciation for possible outcomes.

Charts For Each Case

It is helpful to see how markets behaved during extreme corrections that align with the present day. Therefore, we have included charts for each case. The blue arrow is the hypothetical "similar to the S&P 500 on February 4, 2014". The green arrow denotes where the S&P 500 found a stable bottom.

Why The Study Is Relevant

Are economic conditions in 2014 different relative to the historical cases? Yes, the present day environment is different from all the test cases. However, as described on October 25, the 50-day moving average allows us to monitor the battle between bullish economic conviction and bearish economic conviction. If we examine the "risk-off" charts during the dot-com bear market (2000-2002) and the mortgage/financial crisis bear market, they look the same. Why? The charts do not care why the aggregate opinion shifts from bullish to bearish; the important thing is to monitor the net result or the aggregate opinion (bullish conviction vs. bearish conviction).

Investment Implications - Flexibility Is Key

As noted previously, it is too early to understand the significance of Tuesday's rally in stocks. The weekly chart of the S&P 500 helps us understand why; from a weekly perspective, the S&P 500 is still down 28 points. More importantly, the chart still has a "risk-off" look. We would like to see charts like the one below regain a look that occurs under more favorable risk-reward environments before we shift from an incremental risk-reduction strategy to an incremental cash redeployment strategy.

In Monday's post, we highlighted the rationale for reducing stock exposure and adding bonds to the mix over the past two weeks. Since our approach avoids forecasting and instead calls for observation, flexibility, and incremental adjustments, we can adjust our allocations as the evidence changes. As of Tuesday afternoon, we continue to hold a portfolio that aligns with an indecisive market: U.S. stocks (SPY), technology (QQQ), bonds (TLT), and cash. In terms of which way to migrate, the market will guide us if we are willing to listen.