A divergence in new lows bodes well for stocks
Key points:
- The S&P 500 fell below the lowest low in the last 100 sessions
- At the same time, the percentage of issues at a 252-day low did not exceed the previous peak
- After similar divergences, the S&P 500 had a positive upward bias, especially in the near term
- The Composite Washout Model count increased to 50%, with several new alerts
A divergence in new lows is a hallmark of a bear market bottom
The S&P 500 registered a lower low on Tuesday when it fell below the intraday low from June, which triggered a technical pattern known as a divergence. The setup occurs when an index and an indicator move in opposite directions or fail to confirm each other.
The Composite Washout Model contains three models that measure a divergence between the S&P 500 and the percentage of issues at a 21, 63, and 252-day low.
Bear market bottoms are a process. The divergence between an index and the percentage of issues at a new low is one of the best ways to identify a potential counter-trend rally or a bearish to a bullish trend change.
The highest level of 252-day lows, otherwise known as the maximum point of pain for index issues, typically occurs well before the final low in the index. The 1968-70 bear market is one of the rare exceptions when the maximum percentage of issues at a low coincided with the absolute low in the index.
It's important to note that new lows can show a series of lower peaks in bear markets. For example, the internal low occurred in October 2008 when more than 80% of issues achieved a 252-day low. However, the index bottomed in March 2009, with only 20% of issues at a low.
Similar divergence patterns in new lows preceded positive returns
The new lows divergence signal shows favorable returns, win rates, and z-scores, especially in the first few months. As with most historical studies that include the 1929-32 bear market, the outlook improves dramatically post that period.
I would also note that the signal occurred several times in brutal bear markets like 1973-74, 2000-02, and 2007-08. In most cases, the S&P showed a positive return at some point in the first month.
Several Composite Washout Model members triggered an alert
Over the last five weeks, the relentless equity market decline created an oversold condition for several breadth-based indicators in the Composite Washout Model. On Tuesday, the composite count increased to 50%, with four new alerts.
New Signals:
- 252-day Low Divergence
- 63-Day Low Divergence
- Breadth Washout
- Volume Washout
With the Composite Washout Model count increasing to 50%, a new signal will trigger if S&P 500 price momentum turns positive.
What the research tells us...
The relentless decline over the last five weeks pushed the S&P 500 to a new cycle low. However, while the S&P 500 traded to a new low, several issues within the index failed to register a new 252-day low, creating what is known as a bullish divergence pattern. With several other members in the Composite Washout Model triggering an alert in conjunction with the divergence signal, the weight of the evidence is building for another counter-trend rally.