Should we position for a rally after an 18% decline in the S&P 500

Key points:

• The S&P 500 closed down 18% from its 252-day high last week
• After similar signals, the index closed higher 80% of the time 2 months later
• Instances that stopped short of a 20% decline show even better results

What happens when the S&P 500 declines by 18% from a high?

Let's assess the outlook for the S&P 500 after the index closes down 18% from a 252-day high. I will include a reset that requires the index to close within 1% of a new high before a signal can trigger again. The reset screens out duplicates and identifies the first cross.

Similar signals preceded positive returns 80% of the time

This study generated a signal 20 other times over the past 93 years. After the others, S&P 500 future returns, win rates, and risk/reward profiles look solid across almost all time frames. Suppose a rally develops that eventually becomes a bear market bounce. In that case, the 2-month time frame provides a pretty good window of opportunity whereby we could exit a trade. Except for the 1929 signal, drawdowns were minimal.

The short-term outlook table provides a strong case for an immediate bounce

S&P 500 future returns, win rates, and risk/reward profiles look pretty good in the 1-3 day time frames, especially the 3-day win rate. With S&P futures up significantly as I write my note, the odds of adding to the win rate in the 3-day window look pretty good.

Suppose I create an exit signal for the study that sells when the index crosses below 20% or when 42 trading days expire, whichever comes first. In that case, we see that 40% of the instances never crossed below -20% in the first 2 months. i.e., a multi-month rally commenced without going from -18% to -20%.

Signals that made it 42 days without the S&P 500 going from -18 to -20%

If we look at the instances that never closed down 20% within the first 2 months of a signal, we see a very compelling case for a multi-month rally. Even the 1937 and 2008 signals provided a window of opportunity.

Signals that dropped from -18% to -20% in the first 42 days

The instances where the S&P 500 kept falling and closed down 20% within the first 42 days of the signal show a significantly more muted response across the first few months. The line in the sand at -20% matters.

What the research tells us...

The 18% decline in the S&P 500 provides a window of opportunity for a multi-month rally. Similar setups to what we're seeing now have preceded positive gains, especially in the 2-month time frame. If the index can avoid closing down 20% in the next few months, which is a big question mark, the odds of a multi-month rally improve dramatically.