Indicator of the Week: What Happens After an S&P Snap-Back Rally?

The S&P 500 Index (SPX) went from a three-month low to a record high in short order, so what does that mean for stocks?

Senior Quantitative Analyst
Jul 20, 2016 at 6:30 AM
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It was a tumultuous first two-and-a-half months of 2016, but after that, the S&P 500 Index (SPX) was making steady gains toward its all-time high. Then "Brexit" hit and traders freaked. The SPX endured its biggest two-day drop since mid-2015, falling to its lowest level in over three months. That seems like a long time ago now, with the SPX recently making a new all-time high. This week, I'll take a look at similar times the S&P dropped to lows before spiking to highs in a short amount of time, and see how stocks behaved after these "snap-back rallies." 

Three-Month Lows, Then Highs: So, you have a market at its lowest point in three months, and less than two weeks later it's at its highest point in three months. Is the market exhausted, or is there pent-up buying pressure that pushes the market higher? That's what I'm trying to determine.  

Going back to 1950, this has occurred just 21 other times. The first table below summarizes the returns going forward after these signals. The second table shows returns anytime since 1950 for comparison.

Looking at the average returns shows some S&P outperformance in the first couple of weeks after a signal, but after that the returns revert back to more typical levels. Unfortunately, the most recent signal occurred a little over a week ago, so according to history, the outperforming period is almost through. Sorry for the late notice. On the bright side, across all time frames, the percent positive is higher than usual across the board, and the standard deviation of returns is smaller, indicating less risk than usual. 

                              SPX 3 Month Low Chart 1

Next, I wondered if this most recent signal was a little different because it occurred very near an all-time high. The data in the table below is based on only the signals that occurred within 5% of an all-time high. When you examine the average return after these signals, you get even more outperformance in the first week, followed by underperformance going forward. These signals seem to indicate the probability of a pretty flat market for the next several months.       
SPX 3 Month Low Chart 2

VIX Makes New High Then Low: The CBOE Volatility Index (VIX) measures expected volatility of option prices on S&P 500 options, and it tends to move in the opposite direction as stocks. So it's not a huge surprise that a similar signal, except backwards, occurred for the VIX just a week ago.

Specifically, I'm looking at times when the VIX spiked to a three-month high, and then within a month was down to a three-month low. The VIX is generally thought of as a "fear gauge," so it suggests that traders panicked for a brief moment, and then the panic quickly dwindled into complacency. The table below shows how the SPX performed after these occurrences since 1990 (as far back as we have VIX data).

You can see the 13 previous signals tended to occur just before a weak market. The average return and percent positive after these occurrences are lower across all time frames, compared to the typical market returns since 1990. It's typically not a good sign when market players become complacent.

                                        SPX After Vix Chart 3    

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