Why the Risk-Reward Favors Bears This Week

The Dow tends to pause after its first touch of a new millennium level

Senior Vice President of Research
Nov 28, 2016 at 8:29 AM
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"The blue-chip index closed above 19000 for the first time Tuesday after making a big push higher over the past several trading sessions... Data from Schaeffer's Investment Research shows the Dow tends to jostle around these millennium markers for at least several weeks before breaking through with much conviction... As Schaeffer's data shows, the Dow tends to bounce back from these periods of sluggishness about three months after passing a millennium marker. In that time frame, the Dow averages a 1.65% gain, about half a percentage point better than its average gain during any three-month period."
    -- The Wall Street Journal, November 23, 2016

Last week's commentary observed that many U.S. equity benchmarks were near or trading just above key round numbers, with the potential implication being that the momentum that began immediately after the early November presidential election was vulnerable to stalling, as investors might view these round numbers as an opportune time to trim equity holdings.

The good news for bulls is that those equity benchmarks trading above round numbers going into last week's trading -- the Russell 2000 Index (RUT - 1,347.20), S&P MidCap 400 Index (MID - 1,640.81), and Nasdaq Composite (COMP - 5,398.92) -- continued higher, carving out all-time highs in the process. And the Dow Jones Industrial Average (DJIA - 19,152.14) and S&P 500 Index (SPX - 2,213.35), sitting below the 19,000 and 2,200 levels, respectively, climbed above these round numbers. The Dow's first-ever move through the 19,000 millennium mark grabbed the most attention.

 
Since the Dow first reached 10,000 in 1999, its initial touch of a new millennium level since that period has resulted in underperformance relative to its normal behavior. The good news for bulls is that the historical weakness can be more characterized as a pause preceding a period of outperformance in stocks over the ensuing three months. Additionally, volatility tends to be lower than normal in the three months following the move to a new millennium level, as the standard deviation of returns is lower after a signal relative to the anytime behavior. This is interesting, as most anticipated higher volatility in the days, weeks, and months following a Donald Trump victory.

The table immediately below summarizes how the Dow has performed over various time frames after hitting a new millennium level for the first time since DJIA 10,000. The second table displays how the Dow has typically behaved over a comparable "anytime" period.

dow millennium returns 1127

Since the election, one of the best performing areas of the market is small-cap stocks, as measured by the RUT. As mentioned above, it took out the 1,300 level for the first time, which acted as resistance in June 2015. The index was situated at its 200-day and 320-day moving averages prior to the election, and has rallied about 16% since. Its 14-day Relative Strength Index (RSI) shows that the index is overbought -- but the last time RUT entered an overbought condition (last July), it simply traded sideways, until its 20-day moving average caught up, before it continued higher. Its half-century mark at 1,350 may prove to be a pausing point, just as the 1,250 area was in August and September.  

Moreover, and perhaps of more importance than the RUT 1,300 and 1,350 levels, is the 1,370 level. This level is four times the 2009 low around 350, which also marked the site of major lows in 1997, 1998, and 2002-2003. The levels that correspond to two times, 2.5 times, and 3.5 times these lows have all acted as major speed bumps. The level that represents three times these lows never acted as resistance, however.  
 

rut monthly 1127

With the Thanksgiving holiday last week, Schaeffer's Senior Quantitative Analyst Rocky White looked back at the market's performance in the week after Thanksgiving. He broke the historical returns down based on how the SPX performed during Thanksgiving week.

The table below presents data since 1950. Last week, the SPX closed higher by 1.4%, which falls in the middle column of the three SPX scenarios we researched. Note that it is a coin flip as to whether the following week's finish is higher or lower. However, the average percentage decline during a negative week is more than twice that of the average percentage advance during a positive week. So, based on this study, one could argue the risk-reward this week favors the bears. Bulls, however, should stay the course, and use pullbacks as buying opportunities.

spx post txgiving returns

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