Many traders and investors have been unnerved by the stock market’s recent price action. This is understandable, with the S&P 500’s futures going up and down 1-2% every single day on the intraday.

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Such high volatility is typical of the final 8-12 months before the bull market tops.

Here’s the October 2007 top.

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Here’s the March-September 2000 top.

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The U.S. stock market’s current correction particularly reminds me of the July – August 2007 correction. It was a rather large “small correction” of 10-12%. It was also very short (i.e. approximately 1 month), with LOTS OF VOLATILITY.

But sure enough, the first sign of high volatility was not the end of the bull market.

Here’s the S&P 500 right now.

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Here’s what you should do during periods of high volatility.

1. DO NOT stare at the price every single hour. It will drive you crazy. Up 10 points, then down 20 points, then up 15 points, then down 30 points, then up 35 points. Do not let the market’s recent direction drive your thinking. Independent thinking is critical.
2. Focus on medium term risk:reward. Can the market fall more in the short term? It certainly can. Anything is a possibility because there is no such thing as 100% certainty in the markets. But what matters is probability and risk:reward. E.g. if the market has a short term max downside risk of e.g. 5%, and an upwards target of 10%, that is a 1:2 risk reward ratio.

Here are more signs that the U.S. stock market’s medium term outlook is bullish (ontop of the other recent signs)

*Let’s analyze the stock market’s price action by quantifying technical analysis. For the sake of reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

Something to scare the s*#@ out of you

I saw this on Twitter:

From 1950 – present, there have been 23 historical cases in which the S&P went down more than -3% the previous day and went up more than +1.8% today.

The average drawdown over the next week was more than -5%

Sounds scary, doesn’t it?

Here’s the reality. Most of these historical cases happened AFTER the S&P had already fallen more than 30%. So of course the max drawdowns would be so big. Towards the end of a bear market, volatility is crazy high, so 5% up and down swings are very common. Remember October/November 2008, when the market would easily go up and down a few percent each day.

But of course this doesn’t stop other market commentators from publishing these stats, because hey, bad news sells like hot cakes. Context is very important when looking at market studies.

Here are the historical cases, and what the S&P 500 did next.

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More short term volatility is normal, but this is hardly “end of the world”. 3 months later, the S&P was up all but 2 times. The single big loss case happened in September 2008, AFTER the S&P had already fallen -30% and a recession had started.

Today? The economy is still growing, and the S&P’s decline is just -10%. The most similar case is October 1997 when the U.S. stock market tanked.

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We can look at yesterday’s price action in more detail. The S&P fell more than -3% the previous day, went up more than 1% yesterday, and yesterday was an “inside day” (the daily HIGH was below the previous day’s HIGH, and the daily LOW was below the previous day’s LOW).

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Here’s what happens next to the S&P 500 (historically) when it fell more than -3% the previous day, went up more than 1% today, and today is an “inside day”.

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As you can see, some more short term weakness might follow, but generally it is a medium-long term bullish sign for the stock market.

Nasdaq and Russell are terrible

The Nasdaq and Russell have been significantly weaker than the broad S&P 500 during this “small correction”. (Out of these 3 indices, the Russell is the weakest.)

The Russell has fallen in 26 of the past 40 trading days. This was rare from 1987 – present. Historically, this usually led to a rebound in the Russell on every single time frame.

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Meanwhile, the Nasdaq has gone down 24 of the past 40 trading days. This is neither consistently bullish nor bearish for the Nasdaq.

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Breadth

The Nasdaq 100’s breadth is terrible. Less than 32% of its stocks are above their 200 day moving average.

Here’s what happens next to the Nasdaq 100 when 31% or less of its constituents are above their 200 dma (first time in 3 months).

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As you can see, this is a short term bearish sign for the Nasdaq, but a medium-long term bullish sign

Very interesting comment

James wrote a very interesting comment in yesterday’s post.

I neither agree nor disagree. I just find it interesting that he uses liquidity in this way.

Conclusion

Not much has changed in our market outlook over the past few days.

1. The medium term remains bullish. Volatility is extremely high right now. Since volatility is mean-reverting and moves in the opposite direction of the stock market, this is decisively medium term bullish.
2. The short term is a 50-50 bet right now. Moreover, the stock market is likely to remain volatile in the short term (big up and down swings). 
3. When the stock market’s short term is unclear (as it is most of the time), focus on the medium term. Step back and look at the big picture. Don’t lose yourself in a sea of noise.

At this rate, the Medium-Long Term Model will turn long term bearish in Q2 2019.

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