Three Down Days No Different Than Key Reversal Day

Posted At 8:55 AM EST

Good morning...We begin the day with some buying pressure in the pre-market futures.  We have a big week of major economic releases coming up, along with earnings preannouncements and quarter-end shenanigans, so a good dose of volatility is expected.

Last week we looked at Key Reversal Days in the S&P.  Friday we added to it in terms of looking at when the market followed through to the downside the day after the reversal day.

Due to a number of inquiries, let's update that table from Friday with one other column, which is the number of days it took until the S&P bottomed before beginning its ascent to a new six-month high.

On average, it took the index another two weeks of dropping, by an average of -2.2%, before it formed a low and began rising to a new multi-month high.  However, there was a lot of variability in the figures, ranging from 1 day to 37.

Something notable from the table is that although a few instances bottomed very quickly, it took them quite a long time to actually make it to a new high (see 01/05/96, 12/31/96, 01/24/97 and 01/04/05).

In a similar vein, I was reading something over the weekend (try as I might, I forgot the source) that since the S&P had moved more than 20% away from its 200-day average and then suffered three straight down days, the trend was likely over and we wouldn't be seeing new highs anytime soon.

His theory was that since the market was so incredibly extended (by being so far above its long-term average), and investors weren't very eager to step back in (by suffering three straight down days), then surely we're at some kind of major top.

That's a good contention to test, so let's look at the same kind of study as above.  Here we're looking for those times when the S&P hit at least a six-month high that was at least 20% above its 200-day average, and then dropped for three straight days.

The results in this table look out over the next few months.  In every case except July 1933, the S&P quickly went on to make a new high, within 9 days on average.  Following that July 1933 instance, the S&P ramped 20%+ over the next month or so but never quite made it back to the old highs since the 3-day decline was so steep.

The most notable thing about these precedents is that in every case but one, the third down day marked the exact low before the index marched up to a new high, or at least rallied strongly.

Over the next month, the S&P's return averaged a remarkable +9.4%, with an average maximum loss of a miniscule -0.4% compared to an average maximum gain of +12.0%.

While it's only 7 occurrences, this is one of the most skewed risk/reward ratios we've come across lately.  I wouldn't personally use that as a buy signal, but I most certainly would question the guy who asserted that we must be at a top because of the three down days after stretching 20% above the 200-day average.

There just isn't anything from either study that suggests a high probability that the recent 3-day decline or Key Reversal Day is anything other than a pause before another run at a new multi-month high.

Bottom line - Intermediate-term Outlook: Neutral (since April 9, SPX 843)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested a new bull market.

During mid-April, the market held up extremely well in spite of being overbought.  This is very rare during an ongoing bear market, and added to the idea that "this time is different" in terms of bear market rallies, as we reiterated in early May.

On July 10th, we looked at a number of short-term oversold readings, and like a good market does, it responded by rallying strongly.  The rally since then has been remarkably persistent, rolling over a multitude of indicators and studies that argued for a pullback.

As we discuss ad nauseam, a market that does not respond to short-term extremes usually has more work to do in the direction of the extreme, and that held true this time as well.  Given how well the market has responded to overbought conditions, it does bode well for the coming weeks (see here and here as well).

We've seen some periodic bouts of excessive optimism during that time, and the market has pulled back in the very short-term after them.  But each time, the major indexes have held technical support, and rallied from even intraday oversold readings, so we've seen little change in the uptrend's character just yet.

We'll be watching closely at how the markets recover from the Key Reversal Day on Wednesday.  As noted in the comment on Thursday, the short-term follow-through (or lack thereof) should give us a good clue as to just how important the reversal was.  So far we've seen continued weakness, which argues for a longer time frame before hitting a new high, but still doesn't usher in a high probability of a major top.

Bottom line - Short-term Outlook:  Neutral (since July 23, SPX 955)

Last week, we discussed some short-term warning signs, suggesting that we should finally see another pause in the relentless uptrend.  We got that after a quick pop higher on the FOMC announcement, and by late in the week we actually started to see some oversold signals for the first time in awhile.

My thinking on Friday was that if we saw a bit more selling pressure, into 1035ish on the S&P, that should serve to set us up for another rally attempt.  The S&P cash index made it to 1041, and the futures dipped to 1036 this morning before the 11-point rally we're seeing pre-market.  That lends some credence to the probable support around that 1035ish area, and I'll be looking for more of a recovery as long as we don't drop back below that support.

All the best,