Another step on the road to oversold

Key Points

• Both the Nasdaq 100 and Russell 2000 indexes are finally nearing a level of "oversold" that is typically (though importantly, not always) followed by a reversal of fortune
• Both indexes have now seen the % of component stocks above their respective 200-day moving averages fall to a significantly low level.

QQQ Breath (% > 200 Avg)

The chart below displays all days when the % of stocks comprising ticker QQQ (Invesco QQQ Trust) that were above their 200-day moving average was below 15% and the table displays the summary of QQQ performance in the ensuing 12 months.

At first glance, the results look highly compelling (median 12-month return of +48.9% and 99% Win-Rate). However, this seems like a good time to invoke:

Jay's Trading Maxim #27: When it comes to trading/investing, there can be a chasm a mile wide between theory and reality.

First, the numbers are aided somewhat by the fact that there were many days below 15% leading up to the 2002 and 2009 lows. Secondly, signals in 2002 and 2008 were followed by extreme drawdowns between the initial signal and the actual low. Let's consider only the first new signal in four months to get a more realistic picture. The results appear below.

The numbers are similar but not quite as robust. Still, it is important to note the -33.51% 12-month decline following the 3/10/2008 signal.

The chart below displays the growth of $1 invested in QQQ 12 months after each signal date from the table above.

IWM Breath (% > 200 Avg)

The chart below displays all days when the % of stocks comprising ticker IWM (iShares Russell 2000 ETF) that were above their 200-day moving average was below 14% and the table displays the summary of QQQ performance in the ensuing 12 months.

As we did with QQQ, let's consider only the first new signal in four months.

The chart below displays the growth of $1 invested in IWM 12 months after each signal date from the table above.

What the research tells us…

The good news is that a decline in the % of stocks in the indexes represented above has typically portended significantly higher stock prices in the year ahead. The bad news is that such a signal does NOT constitute an "All Clear" signal. Following a signal, things can - and often do - get notably worse before they get better.

Allocating capital conservatively and adhering to strict risk management is important when acting on the type of signals detailed above.