This pattern occurs during brutal bear markets

Key points:

• The S&P 500 rallied more than 4% over 3 days and then declined by 4% on Wednesday
• The 200-day moving average for the S&P 500 has fallen for 19 consecutive days
• Similar conditions preceded negative returns for stocks in some of the most brutal bear markets in history
• When I isolate the first signal in a bear market, we tend to see a multi-week bounce

This price pattern occurs during brutal bear markets

Let's conduct a study to assess the outlook for the S&P 500 when the index increases by 4% or more in a 3-day period and then subsequently declines by 3% or more on the following day. The study will require the 200-day moving average for the S&P 500 to be sloping downward for 15 consecutive sessions, which is a little less than now.

Similar price patterns preceded negative returns

This study generated a signal 24 other times over the past 92 years. After the others, S&P 500 returns, win rates, and risk/reward profiles were unfavorable across short and medium-term time frames. Interestingly, the pattern did not trigger in brutal bear markets like 1973-74 or 2000-02. Except for the 1929-32 period, the 1-year returns look favorable.

The first signal in a bear market

If we review the first signal in each bear market, the outlook table shows a positive return in every instance in the first 2 months. However, the 6-month window should remind us to utilize a trailing stop.

Where do we stand with an indicator that I'm monitoring closely

In a note on 5/11/22, I shared a study that suggested that if the number of S&P 500 members in a bear market could hold below 63%, the odds of a multi-week bounce looked compelling. So far, we remain below the critical level. You can monitor this indicator on the website. Click here. 

What the research tells us...

When the S&P 500 increases by 4% or more in 3 days and subsequently declines by 3% or more on the following day with a negative trend, we need to be mindful that we are in a brutal bear market environment. Similar setups to what we're seeing now have preceded falling stock prices across short and medium-term time frames. However, the first signal in a downtrend can often lead to a bear market bounce. As always, manage risk appropriately.

The environment remains highly challenging given that the stock market shows all the signs of a brutal bear market typically associated with a recession, yet the Federal Reserve remains hostile.