Short-term Outlook (1-5 Days):  Neutral  From Apr 23, 1215 SPX

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Equity Indicators - Updates and Extremes

McClellan Oscillator

It's times like this that analysts will trot out a few favorite oversold indicators.  There are certainly plenty to choose from at the moment, including almost anything that looks at the short-term.

Instead of showing chart after chart of short-term extremes, I thought it would be more useful to look at something that's a little bit off the radar.  It's a measure we've looked at a few times when we reach a historic reading, it has a longer time frame, and it has a long history.  It's the ratio-adjust McClellan Oscillator.

The Oscillator essentially looks at the momentum of breadth.  When we get a huge change in the number of issues that are advancing versus declining, then the Oscillator will make an unusual reading.  It has done a good job in the past - not just looking at extremes, but also the context of when those extremes occur (such as when the Oscillator showed extreme persistency in March 2009)

On Friday, the Oscillator dipped to an historic reading of -120, the 2nd-most oversold reading in more than 20 years.

Let's go back to 1940 and look for any other time the Oscillator hit this level of oversold while in a bull market (defined as a rising 200-day average on the S&P 500) and see how the S&P performed going forward:

The good news:  we'll probably be higher a few months from now.

The bad news:  it may hurt on the way there.

Over the next few weeks, at some point we usually saw a test back down after any very short-term reflex bounce.  Sometimes, that re-test was pretty painful - the average drawdown was -5.9%.

However, on average, the market formed a major bottom 24 trading days later - it was never less than 13 days or more than 40 days away.  And over the following year, the S&P's average maximum gain was nearly +20%.

New High, Then Large Loss

On Friday, we took a look at "shock days", those one-day wonders that come out of the blue and totally re-adjust what traders think is probable.

Let's look at it one other way.  Let's go back to 1928 and see what's happened whenever the S&P had reached a new 52-week high over the past one or two weeks, and then suddenly erased at least the last two months' worth of gains.

The table below highlights the S&P's performance going forward.

What's most interesting about this is that much of the weakness was concentrated in the first couple of weeks.  After two weeks, the S&P was positive only 29% of the time, but by three months later it was up more than 75% of the time.

By waiting for two weeks to buy and hold for three months, you would have increased your average return from +2.3% to 3.5%, your average maximum gain from +6.5% to +8.0% and reduced your average maximum loss from -5.2% to -4.3%.

Here's another way to look at it:  over the next six months, 60% of your maximum losses would have occurred in the first two weeks.  On 7 of the occasions, more than 75% of your losses happened in the first couple of weeks.

This supports what we looked at above with the McClellan Oscillator and on Friday with the "shock days".  Nothing is guaranteed of course, especially during what seems like so many never-seen-before circumstances, but if we can use history at all, then it's pretty clear that we shouldn't recover and shoot back to new highs without a few big hiccups along the way first.

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