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Aug. 17, 2011, 6:28 p.m. EDT
By Lawrence G. McMillan
MORRISTOWN, N.J. (MarketWatch) "” After some of the wildest gyrations in history, the market has rallied back. Is this just an oversold bounce or something more meaningful?
We're going to try to answer that question with some help from both current technical conditions as well as from market history.
The Standard & Poor's 500 Index /quotes/zigman/3870025 SPX +0.09% is in a bearish pattern of lower highs and lower lows, and until that changes, a certain amount of caution is warranted. Even so, SPX reached extremely oversold levels last week, justifying the current rally that is taking place. By looking at past oversold conditions, we may glean some insight into how far this rally can carry.
S&P 500 by the minute over past 10 days.
One way to verify that "SPX is oversold" is to measure its distance from its 20-day moving average. In order to be able to compare various markets at different times throughout history, we cannot merely use the absolute distance from the moving average, nor can we even use the percent distance from the moving average. Rather we need to use something volatility-based, and thus we must measure the standard deviations that separate the two.
For example, on Monday, Aug. 8, SPX closed at 1119.40, when the 20-day moving average of the index was 1289.5, placing them roughly 170 points apart. At the time, the 20-day historical volatility of SPX had climbed to 32.9%, meaning that 170 points was 8.43 standard deviations. This was the fifth largest differential between the price of SPX and its 20-day moving average, dating back to 1993.
The top five differentials, historically, are:
Further verifying that SPX was oversold recently, there were four separate extreme days in which SPX closed well below its moving average: Aug. 8 ("“8.4F), Aug. 4 ("“7.9F), Aug. 5, ("“6.7F), and Aug.10 ("“6.1F). These are all in the top 46, dating back to 1993.
When the market trades as far below its moving average as that, it is obviously considered oversold. Eventually, SPX will rally back to its declining 20-day moving average, but often the convergence between SPX and the 20-day takes a while and is often accomplished by the moving average declining so far that it eventually runs into SPX, which has stabilized at a lower price. But the first oversold rally is a much sharper thing. And in those cases, the rally is sharp and short-lived and usually carries back to between 1 and 2 standard deviations below its declining 20-day moving average. A rally of that size now would be roughly to the 1210 area on SPX.
For this research, I decided to check the Crash of October 1987 for the same movements. Calculated the same way as the above data, the Crash was "“7.3F below its 20-day moving average. But there is a "catch" here: I am using the 20-day historical volatility calculated at the end of the trading day in question. The crash was so bad that the 20-day historical volatility jumped from 30.8% (pretty high already because of the declines from the week before) to 94.7% in that one day!
Alternatively, if I were to use the 20-day historical volatility from the previous day in the standard deviation calculation, the crash would have been "“22.3F. For those of us who experienced the crash first-hand, 22 standard deviations seems a lot more realistic than 7; there really has never been anything else quite like the crash of "?87.
So a first target for this rally is 1210. The highest target that I can fathom on this initial move is 1260 "” the area of support in March and June. But, once broken, support turns into resistance. The 1260 target would be a slight upside penetration of the 20-day moving average (at 1253 and falling at the rate of about 7 points per day). Oversold rallies often reach similar heights.
The market doesn't usually have a severe decline in August. Yes, there are often August declines (such as 2007 and 2010), but they are not normally the type of severe market trauma that we experienced in the last few weeks.
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