Tuesday's Big Rally Likely Means Absolutely Nothing

I heard two opposing reactions to the huge 6.4% rally on Tuesday. One was the CNBC’esque “the bottom is here” battle cry. And the second was the (rather sophisticated I think) conclusion that these type of big up/down days tend to come in bear markets NOT bull markets, and thus, portend nothing.

I’ve touched on this subject before, looking at volatility and overnight gaps in up vs. down trends (the conclusion was that, by all measures, the market is more volatile in bear markets), but in this report, I want to look at the likelihood of big up or down days like we saw Tuesday.

For this report, I’ll use the zig-zag idea I’ve used in the past to define the trend.

[click to zoom]

[logarithmically-scaled]

The graph above shows a sample snapshot of the zig-zag on the S&P 500 from 1960. Bear trends are red and bulls green. The zig-zag switches between the two trends whenever the market moves against a high or low by 20% or more. Note that the zig-zag “peeks” into the future, meaning you couldn’t use it to trade, but that’s not the point. The point is to understand what the broader trend was at any point in the market’s history, even if trend-following indicators (ex. 50/200-day moving average crossovers) didn’t yet realize it at that moment.

ANALYSIS

Volatility has changed pretty drastically over the market’s history, so it doesn’t make sense to define a “big” day in percentage terms. Instead I’m going to use each day’s % change relative to the standard deviation (SD) of the previous five years. So for instance, Tuesday was up +6.4%. Using this approach, in today’s market that’s +4.5 SD (because at the moment, 1SD = +/-1.4%).

The table below looks at the percentage of all days on the S&P 500 during bullish and bearish trends that exceeded 2, 3, and 4 SDs, since 1960.

How to read this table: take the first line for example. 2.8% of all days during bull trends were up at least 2 SDs (a big up day), but counter-intuitively, 5.2% of all days during bear trends were up by a similar amount.

The table shows that both big up and big down days, regardless of how we define them, were far more likely to happen on any given day during bear markets than bull markets. That would lend credence to the idea that Tuesday’s rally was actually a bearish sign.

But that’s only part of the story. The zig-zag I used for determining up vs down trends, tagged about 80% of all days as a bull trend. Even though on any given bear market day, big up/down days are far more likely to occur, because bear markets happened so infrequently, any given big up/down day is about equally likely to occur during a bull as a bear market.

Whew…that was confusing to write (and probably impossible to read).

In a nutshell, I think anyone who walked away from Tuesday’s rally thinking that in and of itself it meant absolutely nothing was absolutely correct. Yes, big up/down days are more likely to occur on any given bear market day, but because most of the market’s history is up trending, big up/down days are about equally split between bear and bull markets.

Comments

[kelm:]

Yes! You have exposed the fallacy of the Wall Street myth that if you do not remain fully invested and "miss" the x-number of biggest "up" days your returns will be a lot worse. What that means is if you remain invested in a bear market and were to somehow jump out of the market for just those particular days that we see the biggest jump up your returns will be worse over time - well duh.

The biggest up days are during a bear market. Miss the whole thing or most of it and you'll do a lot better.

Tuesday was nothing in the grand scheme of things. Whether we get a rally for some days and a set-up for another drop or go into meander mode like late December is open to question.

Mar 12 08:47 AM

[John Lounsbury:]

Michael - - -

You wrote: "…that was confusing to write (and probably impossible to read)."

Au contraire, your discussion was quite lucid. Thanks.

I would add just one thing: The huge rally days in bear markets are not important, except for the last one, which starts a new bull market. (Yes, some market bottoms occur with a whimper and no huge up days, but often the oppositie is true.)

kelm - - -

Great comment. Who wants to stay invested to get the three up 5% days in a market that overall goes down 30%?

Mar 12 11:41 AM

[Beachboy:]

This is a reasonable sounding assessment of the past decade, however we have entered uncharted territory now and your model has little relevance to the turmoil currently underway. All you are really saying is the market goes up and down as usual...without mountains there are no valleys....

Mar 12 11:58 AM

[henarl:]

Good article and good comments. One cannot absolutely know what is in the future by studying the past but an educated guess is better than raw gambling.

Mar 12 02:10 PM

[fredissy:]

Markets go up and markets go down. The best way to succeed is to buy low and sell high..........duh!! Buy and hold? No, Buy and Hope, or Buy and Hang, or Buy on Hype. The only way out is to have a good way to time the peaks and valleys.

Mar 12 10:12 PM