Where does the Brexit-induced equity drop (so far) rank? On Friday and Monday, the S&P 500 dropped more than 5.3% for its worst two-day sell-off since late August 2015. The immediate- and long-term ramifications of this development are increasing uncertainty—the dreaded word that markets don’t like.
What about a longer-term look at things? Looking at the Brexit pullback so far, it barely registers as meaningful. This doesn’t mean this weakness can’t get worse, but this does help put things in perspective.
Another way to look at the recent weakness is by how many standard deviations away the S&P 500 is from its 21-day moving average. A “standard deviation” is a mathematical term that explains how likely an event is to deviate from the average. Statistics have shown that most events fall on what’s called a normal distribution. This is a fancy way of saying that most events tend to cluster around the middle, or the average; while the further away from the average you go, the less likely the event is to occur. For example, the vast majority of cars on the road are likely driving +/- 10mph from the speed limit. But then, every so often, that one car goes flying by at the speed of light, or you get stuck behind that person driving like a snail. These cars would be the outliers on a normal distribution, and we use standard deviation to mathematically predict what percentage of cars will be in the average, and how many will be outliers.
As a rough guideline, there are approximately 21 trading days in a month, so looking at how many standard deviations the S&P 500 is from its 21-day average is a nice short-term gauge for how overbought/oversold things are. Remember, in a normal distribution, being within one standard deviation happens 68% of the time, within two standard deviations occurs 95% of the time, and within three standard deviations happens 99.7% of the time. Well, the recent drop was greater than three standard deviations, telling you right away how sudden and extreme the drop has been.
Looking back, the other times the S&P 500 closed more than three standard deviations away from its 21-day moving average (since 2013) have usually (three out of four times) marked lows in the price. This is the fifth occurrence since 2013 and the four previous times the S&P 500 moved 2.2%, 3.1%, 3.8%, and down 3.4% one month later.
In conclusion, the sudden drop in equities has been extreme and caught many off guard. At the same time, moves this extreme have the potential to mark near-term lows as well. Be on the lookout for another blog later today looking at the “Black Swan Indicator.”
Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.
The economic forecasts set forth in the presentation may not develop as predicted.
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Oversold: A technical condition that occurs when prices are considered too low and ready for a rally. Oversold conditions can be classified by analyzing the chart pattern or with indicators such as the Relative Strength Index (RSI). A security is sometimes considered oversold when the Relative Strength Index (RSI) is less than 30. It is important to keep in mind that oversold is not necessarily the same as being bullish. It merely infers that the stock has fallen too far too fast and potentially may be due for a reaction rally. The caveat is that sometimes when prices are in an oversold condition they may stay that way until the trend reverses, which is classified as momentum.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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