Market maps and cycle changes

• Posted by DynamicHedge
• on October 26th, 2015

The biggest debate in markets over the past two months is whether the late August drop would lead to a deeper decline and potential recession or whether it’s a buying opportunity.

Let’s look at the patterns which have conditioned investor perception of risk over the bull market cycle.

Below is a chart of every time the S&P lost more than 7.5% over a 20-day period. I’ve highlighted the 60-days after the minimum correction was met.

The statistics (and experience) show that every time there’s a dip, investors are rewarded for buying (or holding). Naturally, this dip buying behavior is a major driver of shallow-dip-to-new-highs paradigm which has defined this market cycle. 5 of the last 6 dips resolved higher after 60-days.

I used the Market Memory algorithms to extract the dominant patterns in 60-days of post-correction price action. I use this to quantify in detail how the market has recovered in the past and map out potential for the future.

The most dominant pattern is to rebound immediately and rally for the full 60 days. The second most dominant pattern retests the lows within ~20 days and then rally for ~40 days.

There were numerous reasons to think the market would trade along the path of a retest and rally rather than a pure “V-bottom”. Most of the fundamental data I follow is still correlates well with bull market performance, so I felt the market would eventually resolve higher, but because the decline was larger and more vicious, the volatility would take longer to drain from the system, leaving the door open for a retest.

We have 20-days left in the 60-day look forward period I’ve used for this study. Most people will find it impossible to believe there is another month left in the rally, but this is the direction the data and historically what has happened.

What happens if it doesn’t?

After a pattern becomes obvious, it will often work for longer than you think possible, just with less effectiveness. Eventually, every analog breaks and reestablishes a fresh pattern as a part of a new regime.

Going forward, the dominant trend in the market will only change when market forces break the dominant investor reward feedback loop. To many, this will sound like a broken record, but as long as the pullback and recovery shown in the Alpha Curves chart are rewarding investors, the playbook stays the same. If we lose 1980 on the $SPX (198.80 $SPY) we can stake a claim that the pattern is broken and enough investors will be on the wrong side of the trade to put the market out of balance and forge a new path. This potential break from history represents the low probability, high reward outcome. However, the higher probability, lower reward outcome is still that we remain in the dominant pattern and continue higher.

I hope this helps clarify some of my thinking around the recent pullback and the lens I’m looking through going forward.

Intense volatility near a recent high is often a precursor to a deeper correction but the market needs to show its hand before you can shift gears. Bigger picture, I agree that the market is due for a much larger correction. However, it might take months for recent liquidity to work thru the system. Given the long-term strength of the market I would be very reluctant to short equities. For the foreseeable future, for most people, flat is as short as you want to be.

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