What Happens When Stocks Are Extremely Oversold?

On Monday, only 1% of stocks in the S&P 500 closed above their 50-day moving average. That was one of the most extreme oversold conditions in history.

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In the past 15 years, the only other times when stocks were this oversold: July 2002, October/November 2008, and August 2011. The short-term results following these data points are mixed, with bounces over the next 5-10 days but lower levels on average looking ahead 3 months. One year later, though, the S&P 500 was positive 100% of the time with an average return of 23%.

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Data Source for all charts/tables herein: Stockcharts.com.

Does an extreme oversold market mean the low is in? Not necessarily…

1) In July 2002, there were a series of oversold readings. From the last one, the S&P 500 would rally almost 25% before giving it all back. The ultimate low was not reached until October 2002.

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2) In October/November 2008, there were a large number of extreme oversold readings. The S&P 500 would bounce roughly 24% and 27% after two of these readings, only to give back all of these gains. The ultimate low did not occur until March 2009.

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3) In August 2011, there were a few extreme oversold readings. The S&P 500 would rally almost 12% after one of these before giving it right back. The ultimate low was reached in October 2011.

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What will happen this time around?

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The 5-10 day bounce is off to a good start, with the S&P 500 rallying 116 points on Wednesday, its largest point gain in history. The 4.96% advance was its largest percentage gain since March 23, 2009.

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If we follow the 2002, 2008, and 2011 examples, an oversold bounce could very well continue in the coming weeks. But any such bounce is unlikely to be a straight up move to new highs. There are likely many sellers waiting up above, hoping for the chance to get back to even. This will create resistance in the near term, with wild swings back and forth likely. If there’s one truism in markets it’s that volatility begets volatility.

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Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more consistent defensive alternative to ...

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