In a little over a month, the S&P 500 has declined more than 11%, giving back all of its gains on the year.
This is the largest decline since … well, earlier this year. Corrections in markets are the norm, not the exception. Since March 2009, there have been 23 of them…
That said, all corrections are not equivalent. There are shallow corrections where little technical damage is done and new highs are achieved shortly thereafter, and there are deeper corrections where the recovery period can be lengthy, measured in months or even years.
When a decline starts, it is impossible to tell which kind of correction you are dealing with. But at a certain point, signs tend to present themselves.
One of these signs is an “oversold extreme” condition rarely seen in shallow corrections. A way to quantify such an extreme is to measure the percent of stocks in the S&P 500 above their respective 50-day moving average. When the percentage reaches a very low level (few stocks above the 50-day), it can be a sign of indiscriminate selling.
We’re seeing that today with only 11% of stocks above their 50-day moving average. This is more oversold than 97% of historical readings (data goes back to December 2001).
What happens after such oversold extremes are reached?
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. Over the subsequent 1-year period, stocks have gained an average of 22.7% with positive returns 93% of the time following extreme oversold readings versus a gain of 9.9% and 84% positive in other periods. Looking out five years into the future, stocks have posted positive returns 100% of the time following such readings.
These are just averages, of course, masking the wide range of outcomes that have actually occurred.
Bounces come in many forms. Let’s review them next…
