Consolidation Required?

The rally last week pushed the S&P 500 over its 50-day moving average for the first time in 2016 — or the first time in 38 trading days, to be exact. That was the longest streak under the 50-day since a 52-day streak back in 2011.

This is a development that most market participants believe leads to a breakout of optimism, but history does not support that conclusion.

Bespoke Investment Group analysts rifled their database, and they found 19 prior streaks of 35 trading days or more below the 50-day over the past 30 years. The results for the next day and week are shown in the table below. The date shown is the day the index finally closed back above its 50-day, thus ending the streak.

It’s interesting to see that the market has historically seen a pullback over the next day and week following breaks back above the 50-day average. Returns are especially negative over the next week, where the S&P 500 has averaged a decline of 0.63%.

The last two occurrences have been exceptions, though, as the data shows that the weeks following the 2011 and 2015 breaks back above the 50-day were slightly positive.

Bottom line: By the time the index breaks its 50-day after a long drought, it is typically very overbought and a consolidation is required before going higher. It certainly seems to be working out that way this time as well.

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REVERSAL PSYCHOLOGY

The action on Feb. 24 amounted to an “outside reversal day” or “key reversal,” which means the high was higher than the previous day’s high and the low was lower than the previous day’s low, and the close was a reversal of the prior day’s close. The feeling is that a low was rejected.

Many market participants get excited about outside reversal days because it seems logical that they would continue in the direction of the close. But the reality is that this pattern is wildly inconsistent going forward and really means almost nothing.

Jason Goepfert, of Sundial Capital, notes that similar reversals led to future performance that was in line with random to slightly worse. iShares Russell 2000 (IWM) put in an outside day, opening below the prior day’s low then closing above its high. In previous similar situations, the Russell 2000 added to its gains only 41% of the time. It got much better after that. By three weeks later, IWM was higher 68% of the time (21 out of 31 occurrences), averaging +1.9%.

Goepfert notes that if you stipulate that the fund had set a multi-month low within the past two weeks, then the outside reversal days led to further gains over the next three weeks all six times it occurred, with gains of at least 3% each time and a better than 2-to-1 reward-to-risk ratio.

Rennie Yang, of Market Tells, made a similar finding. He noted that the S&P 500 was down 1.6% at the low of the day Wednesday before recovering to finish up 0.4%. This type of action, he reports, usually leads to a lower close (below the setup day’s close) within the next couple of sessions. Over the last 30 occurrences, stretching back to 2002, 25 (83%) led to a lower SPX one or two days later, well above the 59% random odds.

In plain English, Yang’s study suggests that in the next week, the S&P 500 is likely to fall beneath Wednesday’s 1,891 low.

That’s far from most market participants’ expectations, which means it has a good shot at being right.

Best wishes,

Jon Markman

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