Monday’s breakdown in the S&P 500 Index to a new low, followed by a sharp rally above the previous support level, is an unusual event that has drawn a lot of chatter in the market. The key question is simple: What’s a more important signal for future performance — the breakdown or the subsequent rally? Based on the previous times this chart pattern has printed during tough markets, this week’s events are actually a very bullish sign.
The criteria for this is analysis straightforward: We’re looking for sizable downturns where support was breached intraday, but where the market closed above support (as happened Tuesday) then moved higher the next day (which occurred Wednesday).
Click to EnlargeFirst, consider the events of 1990-91. From its July 1990 high through its late September low, the S&P 500 fell about 20%, bounced, then briefly traded just below its previous low in the second week of October. The market recovered on the day of the breakdown to close at support and rallied the next day, just as we saw in the first half of this week. This proved to be a major bottom: the market went on to rally approximately 25% in the next four months, the beginning of a bull market move that lasted until early 1994 and brought the index to a high above 480.
Click to Enlarge Next up is the final downturn that preceded the late 1990s bull market. After bouncing around for most of 1994, the market sold off late in the year, rallied briefly, then touched a new low but recovered that same day. The S&P stood 8% higher three months later, and a new bull market was born.
Click to Enlarge The Russia/Long Term Capital Management swoon of late 1998 paints almost exactly the same picture as the current chart: a sharp downturn followed by a rebound, a subsequent failure and turnaround, and a powerful rally to close out the year. This upturn lasted until the market finally topped in March 2000:
Click to Enlarge There were two other occasions where this same formation was followed by a rally: 4Q 2002 and 1Q 2008. In the case of late 2002, the rally didn’t prove sustainable, but it still set the stage for a nice 22% trading move. Also, even though stocks moved to new lows in early 2003, the S&P stood a full 45% higher one year after this formation printed.
Click to Enlarge In 2008, of course, the market subsequently plummeted later in the year once the financial crisis took hold. The signal proved false in this case, but there still was time to cash in on an 11% rally in the next two months before stocks began to fall apart.
Note that in almost every instance, there was quite a bit of noise in the two weeks following the reversal day. But as long as the prior support level holds — in this case, 1,100 on the S&P — these charts can continue to be a guide.
Like all things technical, this pattern isn’t infallible. In May 2004, the market only rallied about 5.5% off a false breakdown before giving out and sliding to fresh lows. What’s more, the current environment is far different from almost anything we’ve experienced, save for the 2008-09 market crisis. Headline risk is off the charts, so additional trouble in Europe or an exceptionally bad jobs report Friday could kill this nascent rally before it even gets off the ground. Still, history indicates that the odds might finally be starting to swing back in favor of the bulls.
