How The Recent Stock Market Crash Is Just Like In 1987

The stock market is making an oversold bounce right now, and has reached its first fib retracement (23.6%). The standard target for a bounce is 38.2% – 50%

Go here to understand our fundamentals-driven long term outlook.

Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are walking blindly into the future.

Buy the dip, like 1987?

The past week has been crazy.

The S&P 500 tanked and then surged.

From 1927 – present, there has been only 1 other case (other than right now) in which the S&P 500 fell more than -1.5% for 4 days in a row, and then went up more than 5.8% over the next 2 days:

1987

We can loosen the study’s parameters, and see what happens next to the S&P 500 when it fell more than -1.5% for 4 consecutive days and then went up more than 4% in 1 day

Once again, this is extremely rare.

Both cases saw the S&P 500 rally, retest, and eventually push higher.

n = 2, so take this study with a grain of salt.

Either way, this illustrates how such crashes typically have a retracement rally and then a retest.

Will the retest be like 1962, 1987, 1998, and 2011?

After the stock market rallies and retests, will it push higher to make new all-time highs? Or is this the start of a much bigger bear market?

(It is not unprecedented for the stock market to have 20% declines without a recession. This happened in 1962, 1987, 1998, 2011).

Here’s the S&P 500 in 1962

Here’s the S&P in 1987

Here’s the S&P 500 in 1998

Here’s the S&P 500 in 2011

What happens next depends on macro:

1. If macro (the U.S. economy) improves (e.g. in 1962, 1987, 1998, 2011), then the stock market will push on to new highs.
2. If macro continues to deteriorate, then the stock market will push on to new lows and a recession will ensue.

*Macro started to deteriorate in August, before the recent 20% decline

There will be a fork in the road, and that fork in the road will be determined by the state of the U.S. economy. In times like right now, it’s better to predict the next 1-2 steps instead of the next 10 steps.

Unfortunately, this economic expansion is almost “as good as it gets”, which means that a post-1962 multi-year rally is unlikely. I think the most optimistic scenario is a 1 year rally like 1999.

Fast drop

One of the most notable things about the recent 20% decline is how fast this was.

1. 20% big corrections can be fast
2. The start of a bear market tends to be much slower because many people are still buying the dips, thereby slowing down the pace of the decline. (These are the people who have been conditioned by the long bull market to never stop buying stocks).

So when the stock market makes a quick 20% decline, it’s usually not the start of a much bigger bear market.

Here’s what happened next to the S&P 500 when it fell more than -19% from a 2 year high in less than 3 months.

*Data from 1927 – present

As you can see, this was indeed bullish for stocks post-WWII. But this is also how the 1929 crash started.

I don’t think this study is as bullish as it seems.

1. In the past, it made sense why bear markets would start slowly.
2. But with a faster flow of information (thanks to the internet) and the rising popularity of ETFs, it is very possible for much bigger declines to begin with a fierce selloff (e.g. right now).

Price action changes over the decades.

AAII

Sentiment is still quite fearful. AAII Bears has exceeded 47% for 2 weeks in a row. Here’s what the S&P 500 did next.

Buy the dip

Today’s intraday reversal was quite amazing. The S&P 500 fell more than -1.8% from the OPEN to the LOW, and then closed more than 0.8% above yesterday’s CLOSE.

Here’s what happened next to the S&P 500 when it fell more than -1.8% from the OPEN to the LOW, and then closed more than 0.8% above yesterday’s CLOSE.

*Data from 1927 – present

As you can see, this is not consistently bullish or bearish on any time frame.

XLF

I have continued to highlight the problem with finance stocks during the recent stock market decline. This is not necessarily a long term bearish sign for the stock market, but it certainly is a long term warning sign.

The financial sector tends to underperform towards the end of a bull market and economic expansion. This happened throughout 1999 and 2007

Here’s what happened next to the S&P 500 when XLF fell more than -18% over the past year while the S&P 500 fell less than -13%

*Data from 1999 – present

1. This was a long term warning sign (but not necessarily a long term bearish sign).
2. But even in the bear market cases (2000 and 2007), the stock market did ok over the next 6 months.

NYSI and NASI

The NYSE McClellan Summation Index and NASDAQ McClellan Summation Index are breadth indicators.

Both of these breadth indicators are very low right now.

Here’s what happened next to the S&P 500 when the NYSE McClellan Summation Index fell below -1000

*Data from 1998 – present

Here’s what happens next to the S&P 500 when the NASDAQ McClellan Summation Index fell below -1240

*Data from 1998 – present

The sample size is small, but the message is clear and illustrates how extreme the recent selloff is.

When breadth becomes very low, the stock market tends to rally and then retest

Amazon (NASDAQ:AMZN)

As CNBC noted, this is Amazon’s worst quarter since the 2008 financial crisis.

Here’s every single quarter in which Amazon fell more than -25% in 1 quarter

You can see this as a bear market sign, but I wouldn’t read too much into this. Using 1 stock to gauge the entire stock market is like using 1 tree to gauge the health of the entire forest.

Click here for yesterday’s market studies

Conclusion

Here is our discretionary market outlook:

1. For the first time since 2009, the U.S. stock market’s long term risk:reward is no longer bullish. This doesn’t necessarily mean that the bull market is over. We’re merely talking about long term risk:reward.
2. The medium term direction is still bullish (i.e. trend for the next 6 months). However, if this is the start of a bear market, bear market rallies typically last 3 months. They are shorter in duration. Bear market rallies are choppy and fierce.
3. The short term is a 50/50 bet

Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.

Our discretionary outlook is not a reflection of how we’re trading the markets right now. We trade based on our quantitative trading models, such as the Medium-Long Term Model.

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