What Happens After Big Upside Reversals?

The past month has presented a seemingly extraordinary situation in the markets with the S&P 500 at one point falling nearly 10%, then recovering to significant new highs within weeks.  Some observers view the move as unsustainable and a sign that significant trouble still lurks ahead for markets.  We thought it would be interesting to see how the S&P 500 has actually performed historically in the wake of sharp v-shaped reversals like the one we just witnessed.

First, we needed to come up with a precise definition of what constitutes a sharp upside reversal.  Please bear with us here.  To start, we calculated the mean difference between the S&P 500’s daily closing price and the daily 50-day trailing moving average since 1955.  We then calculated the standard deviation statistic for that mean difference.  For the uninitiated, standard deviation gives us a sense statistically of how significant a move has occurred below or above a mean.  For instance, under a normal “bell curve” approximately 66% of outcomes should be with + or – 1 standard deviation of the mean and approximately 95% should be within + or – 2 standard deviations of the mean. In this case, we looked for all trading days since 1955 in which the number of standard deviations from the mean (also known as a “z-score”) in terms of distance from the 50-day moving average was 2 or more z-score points above the z-score from 25 days prior (basically 5 trading weeks).  In other words, if the S&P 500 closed 2 standard deviations below the 50-day moving average five weeks ago, and closed 1 standard deviation above the 50-day moving average today, that would count as a reversal (the z-score difference would be 3 in this example).  

As others have observed, this turns out to be a somewhat rare occurrence.  Overall, there were 14,993 trading days in our sample.  703 days, or 4.7%, met the criteria set out above for a significant upside reversal close.  Keep in mind though that these days tend to cluster in bunches, so there can be long periods of time between market periods exhibiting this type of behavior.  

How does the market perform, on average, in the wake of these upside reversals?  Quite well actually.  It appears that the good performance carries on.  We looked at performance 90 trading days, 270 trading days, and 540 trading days from a reversal trigger day.  The data is below.  

As you can see, for each of the three time intervals, short-term to long-term, the average performance following reversal trigger days was higher than normal.  The difference in average performance is statistically significant for all three time-intervals at the 99% level.  And, for the 90 and 270-day time intervals, the percentage of negative outcomes after reversals was solidly lower than for the overall data set.  At the 540-day interval, the percentage of negative outcomes was slightly higher.  

Does this mean the market is guaranteed to jump 10% to 20% over the next year or so now that we’ve observed a sharp upside reversal period?  Of course not.  As one would expect, there were plenty of negative results to be found in these data sets, with the ‘73/’74, ‘00/’02 and ‘07/’09 mega bear periods providing some particularly gory outcomes.  Nonetheless, the outcomes show that volatile reversals of the sort we just observed in recent weeks more often lead to periods of significantly better than normal performance moving forward instead of major pain, especially when the reversals happen in the middle of a benign economic and market performance period.  If we see reversal events like this crop up in conjunction with deterioration in the overall fundamental market and economic backdrop, we’ll begin to raise our eyebrows, though.

What’s Working Globally: Sector Relative Strength Overview

A few weeks ago, we discussed the fact that EAFE markets had reached record relative strength lows vs. US markets.  This week, taking the relative strength work in a different direction, we look at which sectors in the MSCI World index have been outperforming and which have been lagging, perhaps giving us a little extra insight into overall market direction.

First, here are the relative strength charts for each sector index relative to the overall MSCI World index.  Upward sloping lines show relative outperformance; downward sloping lines show relative underperformance.  We’ve added a 30-week moving average for the ratio to help with the trend visual.

From the above we see the following sectors currently displaying relative strength ratios above the 30-week moving average:

• Consumer Discretionary (But barely—the trend has been down this year)
• Consumer Staples
• Information Technology
• Health Care
• Utilities
• Telecom Services

The following ratios have fallen below the 30-week moving average:

• Materials
• Financials
• Energy
• Industrials

It should be noted that the Consumer Discretionary sector has struggled on a relative basis for most of the year following a long period of outperformance off the 2009 lows and has barely moved back above the trendline.  We’d continue to classify this sector as residing in a “danger zone” even though it’s acted better recently.  

What are some other off-the-cuff observations?

• Move Consumer Discretionary into the “weaker” camp as discussed above and we get an overall picture of economically sensitive sectors lagging while the traditionally “defensive” sectors display relative strength.  The recent rally off the correction lows hasn’t meaningfully changed this dynamic.  Yes, relative strength in sectors like Industrials and Consumer Discretionary have outperformed in recent weeks, but remains well off the levels observed at the beginning of the year.  We know the US specifically is performing well economically.  The “defensive beating sensitive” dynamic in global indices, however, reflects the spotty economic situation observed this year in Europe and Asia.  Subdued demand from mainland China hasn’t helped (see Materials and Energy below, for instance).
• From approximately 2000 to 2008, the relative strength ratios for the Energy and Materials sectors nearly tripled.  After nearly a decade of outstanding relative outperformance, Energy and Materials names have been really tough relative investments over the past several years, as one might expect after a strong run.  The recent significant price declines in oil and other commodity markets have accelerated the underperformance trends. Looking at the charts, relative strength support levels have been broken and there seems to be little reason at this point why this situation should change meaningfully anytime soon. The Energy sector looks particularly vulnerable.
• Ditto for global Financial stocks. Overall, Financial companies haven’t been able to get out of their own way since the beginning of 2010.  Global economic weakness, scandals (Forex-rigging fines provide the latest examples), and other factors have kept them stuck in the mud.  If and when these companies regain their footing from a regulatory, management, and economic standpoint, there’s significant room for upside here though.  
• Telecom Services have been a performance wasteland since the heady days at the end of the tech/telecom boom of the late 1990s, despite the fact the globe has witnessed an amazing transformation and expansion in global telecom and data networks.  Overcapacity and debt hangovers following the late 90s party have morphed into other issues, such as heavy investment requirements for new networks and low returns on that invested capital, competition, and saturation.  Against this backdrop, it’s easy to understand global telecoms’ reticence to embrace “net neutrality.”  Fundamentally, it’s hard at this point to see why this sector can break out to the upside on a relative performance basis.  Like financials, though, if these companies can get it together, there’s plenty of room to run.
• In contrast, the broader Information Technology sector is starting to show some solid relative strength after a 10-year period of market-matching performance.  While many investors have spent considerable energy following Apple, some of the old-school large-cap tech names like Microsoft and Intel, which have considerable influence over overall sector performance, have quietly demonstrated strong performance this year after trading sideways for much of the past decade.
• Health Care refuses to slow down.  Over the past two decades, Health Care has been the biggest outperformer in the MSCI World.  Demographic change, ever-rising health care costs and spending, and initiatives like the ACA have propelled health care higher at various stages in the cycle.  As seen with sectors like Energy, IT, and Telecom at various points in time, strong spikes higher in relative strength have often been followed by hangovers.  Health Care isn’t showing any cracks right now.  This sector will be interesting to watch in coming years, though, as governments and consumers look to put a lid on health-care costs.
• Here’s a final interesting tidbit.  Since 1995, the global Consumer Staples index has outperformed the Consumer Discretionary index significantly (347% to 204%).  Considering the fact the world has seen hundreds of millions of people from emerging markets such as China enter global consumption channels, and that consumer debt in developed economies increased significantly over that time period, we find it somewhat surprising that performance has accrued to consumer “needs” over consumer “wants.”