Composite Washout Model signals are increasing again

Key points:

• The percentage of S&P 500 issues registering a 21-day low cycled from > 85% to < 24%
• The percentage of S&P 500 issues oversold cycled from > 90% to < 43%
• After similar breadth divergences, the S&P 500 had a positive upward bias over the next few months
• The Composite Washout Model count increased to 70%, with two new alerts

The Composite Washout Model

The S&P 500 registered a lower low on Tuesday, which triggered two new Composite Washout Model alerts that identify a divergence between the index and market breadth indicators. 

Bullish market divergence signals play a crucial role in the Composite Washout Model, with four components using the pattern. In the case of the washout model, the alert identifies when downside participation from index members decreases as the index registers lower lows.

A bullish divergence in new lows

A 21-day new low divergence signal was triggered at the close of trading on Tuesday when the percentage of S&P 500 issues registering a 21-day low contracted on the lower low in the index.

Similar divergence patterns in new lows preceded positive returns 

While returns are positive in the first few months, the signal is front-loaded, with the best outlook across short to medium-term time frames coming in the first two weeks. The 3-month window suggests one should expect a choppy bottoming process.

A bullish divergence in oversold issues

A percent of issues oversold divergence signal was triggered at the close of trading on Tuesday when the percentage of S&P 500 issues oversold (14-Day Stochastic < 20) contracted on the lower low in the index. The Stochastic Oscillator (Stochastic for short) identifies overbought or oversold conditions by measuring the closing price of a security to a range of prices over a lookback period. 

Similar divergence patterns in oversold issues preceded positive returns

A divergence signal using the stochastic oscillator provides solid returns, win rates, and z-scores across all time frames. The medium-term windows provide the best outlook, especially two months later.

"A single arrow is easily broken, but not ten in a bundle" - Japanese proverb

With the new alerts, the Composite Washout Model count increased to 70%, representing the highest level in the current drawdown phase. 

The threshold level for an overall Composite Washout Model was eclipsed on September 27 when the count increased to 50%. However, S&P 500 price momentum has failed to turn positive within an alert window, which is why a composite alert remains absent. The momentum condition prevents the model from catching a falling knife. 

Signals:

1. 252-day Low Divergence
2. 63-Day Low Divergence
3. Breadth Washout
4. Volume Washout
5. Oversold Extreme
6. Oversold Divergence
7. 21-Day Low Divergence

What the research tells us...

With two new alerts from members in the Composite Washout Model, the S&P 500 should catch a bid in response to the oversold condition. If price momentum turns positive, the overall composite could trigger the second alert since the start of the current bear market. The previous signal from June led to a substantial counter-trend rally. Remember, a market that fails to respond to an oversold condition is typically one that wants to go lower.