Education Trading Psychology

Very Oversold Stock Market: Is It Time To Buy?

The U.S. stock market is dramatically oversold, with very negative breadth.  One way of capturing that is to look at the percentage of stocks in the SPX that are trading above their 3, 5, 10, 20, and 50-day moving averages.  That percentage, in each case, is below 10.  More than 90% of all stocks are in bear modes.

This is an unusual condition.  I went back to 2006 (almost 4000 trading days) and could only find 26 examples of such uniform bearishness.  The occasions tended to cluster:  eight of them occurred in the latter part of 2008; five of them in the February-March period of 2020; four of them in May and June of 2010.  

Did broadly oversold lead to trading opportunity?

Twenty days later, the market was up 17 times, down 9 for an average gain of +2.42%.  That compares with an average 20-day gain of +.67% for all other occasions.  The average gain for the oversold markets was even greater when looking 50 days out:  +8.20% versus +1.98%, with 21 occasions up, 5 down.

That did not mean that we rose in a straight line.  Twenty of the 26 occasions posted a lower close within a ten-day period; 15 of those 20 occasions dropped more than 2%.  The occasions in September and October, 2008 and the 2020 occasions were especially problematic, dropping another double-digit amount before stabilizing.

We’ve all heard about the person who couldn’t swim and who jumped into the water because it averaged only 4 feet in depth.  Averages, in themselves, don’t tell us about the variability around those averages.  What we’ve seen after broadly oversold markets is average gains on an intermediate-term basis, but significant variability in the short-term and further weakness on some occasions further out.

Positive average returns don’t mitigate the need for sound risk management.  If central banks need to see significantly weaker economies to crush inflation, then stock markets can be expected to anticipate that weakness.  The average individual investor is long stocks and long bonds.  Both positions are getting crushed and could see real disaster if central banks need to continue to administer harsh medicine.
Further Readings:

Using Breadth and Strength to Track Market Cycles

Understanding Market Cycles

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