There are five types of stock-market bounces out there, according to Charlie Bilello of Pension Partners. If you can tell the good ones from the bad, well, you’re probably too busy counting profits to read this story. But if you can’t — and, be real, you probably can’t — this guide might help.
First off, let’s assess just how ugly it’s gotten out there.
To start the week, the stock market had coughed up all its gains for the year, and, according to Bilello, we’re looking at “oversold extreme” conditions. He pointed out that 11% of stocks on the S&P SPX, +1.09% are trading above their 50-day moving average, which is more “oversold” than 97% of historical readings.
Enter the Trump-pleasing bounce:
Stock Market up more than 400 points yesterday. Today looks to be another good one. Companies earnings are great!
— Donald J. Trump (@realDonaldTrump) October 31, 2018
The buying spilled over into Wednesday, with the Dow Jones Industrial Average DJIA, +0.97% and S&P both rallying about 1%. The Nasdaq COMP, +2.01% fared even better with a 2% jump.
But is this oversold reading a good thing for the longer term?
“Stocks tend to bounce, with above-average forward returns in most periods with a higher probability of a positive return than your typical trading day,” Bilello said.
When this extreme reading has been breached previously, stocks have gained an average of 22.7% over the subsequent year, with positive returns 93% of the time. That’s compared with a gain of 9.9% and 84% positive in other periods.
So what kind of bounce is this? Bilello tackles the possibilities:
The last hurrah
Bulls are hoping that this isn’t the one. The textbook example of this took place in 2007, when the August low turned into a 15% bounce for the S&P that took the index back to record highs in October. Stocks didn’t hit another high again until 2013, suffering a nasty 57% bruising along the way.
The dead cat
The bane of day traders everywhere — every one of them has endured a dead-cat misfire at some point. Bilello pointed, as an example, to January 2008, when the S&P dropped to “oversold extreme” levels and bounced 13% from its early-year low to a May high, “fooling many into believing that the cat who bounced after hitting the ground was alive and well.” Less than a year later, and the broad market gauge had lost more than half its value.
The falling knife
This one is no walk in the park, either. The idea here, of course, is that trying to time a market rebound can be brutal. “What they never tell you is how to differentiate between a falling knife and one that has already hit the ground,” Bilello wrote. He used an example from Sept. 29, 2008, when the S&P was at “oversold extreme” and was down 30% from its October 2007 high. Worst must be over, right? It fell another 32% over the next two months amid daily “oversold extreme” readings.
The holy grail
Sorry, guys, but this one’s off the table. These are those wonderful gifts that arrive at the end of bear markets and enrich those savvy — or lucky — enough to get in on the upside action. “In March 2009, we saw a series of these extremes,” Bilello said, “after which the market never looked back.”
The BTFD
Anybody who’s paid any attention to the market action over the past decade knows all about the “buy the f—ing dip” approach. It’s been one of the most effective strategies during this bull market, where nearly every decline has been met with an immediate return to new highs. Until now.
So which one does Bilello believe we should expect from here?
“The best we can say is that extreme oversold conditions tend to lead to above-average forward returns with a higher probability of a positive outcome than other periods,” he wrote. “But these are just probabilities — there are many, many exceptions. Will the current reading fall into the ‘tend to’ category or the ‘exception’ category?”
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