Friday, March 17, 2023
- The fallout from this month’s banking turmoil created a wave of technical damage across U.S. equity markets. Based on the degree of oversold conditions registered this week, a potential relief rally for stocks could be on the horizon.
- Since 1990, whenever 20% or more of the S&P 500 reached oversold levels, as occurred this week, the index has traded higher by an average of 4.2% over the following three months, outpacing the average three-month return by 2.0% during this timeframe.
- While the 200-day moving average is key to the market’s uptrend, holding above support from the December lows (3,783) is key to the recovery narrative.
- A breakdown below 3,783 would raise the odds for a retest of the October lows and trigger a bearish signal in the December Low indicator.
December Lows on Watch
The fallout from this month’s banking turmoil has created a wave of technical destruction across U.S. equity markets. The shuttering of Silicon Valley Bank (SIVB) and Signature Bank (SBNY) along with this week’s crisis in Credit Suisse (CS) drove the S&P 500 down nearly 5% from the March highs before stocks found support near the December lows and pared some of their losses this week.
The breakdown in the banking sector quickly shifted investor concerns from higher-for-longer monetary policy to rising recession risk, which has been well-telegraphed by a sharp drop in Treasury yields and a significant downgrade of the terminal rate in the fed funds futures market. For more information on the recent banking crisis check out our blog posts from March 13 (Dissecting Recent Bank Failures) and March 16 (Update on Credit Suisse Situation).
Recovery or Another Bear Market Rally?
With the S&P 500 recently breaking below its uptrend off the October lows, the recovery narrative has faced increased scrutiny. Market breadth remains damaged, and oversold conditions have become widespread. As shown in the chart below, 24% of S&P 500 stocks reached oversold levels earlier this week based on a Relative Strength Index (RSI) reading of 30 or less. For reference, RSI is a momentum indicator that oscillates between zero and 100. In general, readings above 70 are considered overbought and readings below 30 are considered oversold.
Does Oversold Mean it’s Over?
The financial sector had the highest percentage of oversold stocks this week at 72%. Important to note oversold does not always mean the selling pressure is over, but at extremes, it can foreshadow a potential relief rally. We backtested this theory for the S&P 500 using comparable oversold conditions dating back to 1990. Our model entered buy positions when the percentage of oversold S&P 500 stocks crossed above 20%, filtered for trades occurring at least two weeks apart. We then ran the same analysis for the financial sector but moved the crossover threshold to 50%
For the S&P 500, the model generated both positive absolute and relative returns. For example, when the percentage of oversold S&P 500 stocks crossed above 20%, the forward 12-month average return for the index was 12.2%. This was 2.9% above all S&P 500 12-month returns since 1990. Returns for the financial sector were also constructive, though not until the time horizon is extended out to 12 months.
Back to December?
Yesterday’s rally lifted the S&P 500 back above the 200-day moving average, a bullish sign for the broader market’s trend. However, the December lows at 3,783 are less than 5% away, which is a little too close for comfort given the recent volatility. A break below 3,783 would raise the odds for a retest of the October lows and helps make a case for the market’s gains from mid-October through early February being labeled another bear market rally. Fortunately, most stocks within the S&P 500 are still holding above their December lows, including over 80% of consumer discretionary and information technology stocks, which collectively represent nearly 40% of the entire index.
Finally, if the S&P 500 does violate its December lows within the first quarter, it would trigger a bearish signal on the December Low indicator. This indicator was defined by analyst and Forbes writer Lucien Hooper back in the 1970s. He observed that whenever the Dow Jones Industrial Average (DJIA) violated its December low within the first quarter (Q1) of the following year, it was an ominous sign for stocks for the remainder of the year. In contrast, if the DJIA held above the December low in Q1, it was a bullish sign for the market. Worth noting, the DJIA did violate its December low this quarter; however, we updated the study to reflect the broader S&P 500 index.
As shown in the table below, the December Low indicator has an impressive track record. For years when the S&P 500 held above the December low in Q1, the average annual return has been 18.5%, with 94% of years also finishing positive. When the S&P 500 violated the December low in Q1, the index only generated a modest average annual return of 0.4%, with only 53% of years producing a positive return.
The average return progression between years when the S&P 500 stays above the December low in Q1 compared to years when the S&P 500 violates the December low in Q1 is shown below. For additional context, the return progression for 2023 is also shown, along with the average return progression for all periods going back to 1950.
When the S&P 500 holds above the December lows in Q1, the index has historically climbed steadily higher throughout the year, although at a slightly slower pace for the remaining quarters. What we also found interesting is that for years when the December low was violated, downside was relatively limited for the remainder of the year. In fact, the average low for the year occurred near the end of March and was followed by a consolidation pattern for the rest of the year.
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