Wednesday, February 6, 2008

Mean Reversion After Big Drops

Eddy Elfenbein at Crossing Wall Street has a nice little graphic and commentary up today: How the Market Behaves on Big Down Days.

After researching the 37 instances in which the S&P 500 index dropped 3.2% or more (as it did yesterday), Elfenbein draws the following conclusions:

“The average loss for the sell-off is 5.01%. After that, nearly every day is an up day. By the ninth day, the S&P 500 is down 3.48%, which is indeed, a retracement of about one-third. The market still trends higher to the 17th day where it's down just 3.01%, or about a 40% retracement. At that point, the linger effects of the sell-off seem to dissolve.”

Elfenbein’s findings should come as no surprise to those who pay attention to the TRIN and ISEE, as well as the VIX, various market breadth indicators, etc. While volatility has been on the tame side lately, the TRIN, ISEE, and McClellan Summation Index have all been suggesting a strong oversold situation and a high probability mean reversion bullish entry.

The duration of the retracement pattern identified by Elfenbein is also worth noting, as it hearkens back to some work on VIX spike retracements I published last April in Lessons from the Post-2/27 VIX Price Action, where the optimal retracement window was determined to be about eight days.


Jeff Pietsch CFA said...

Do I understand correctly that another 5% has historically been shaved in the ensuing two to three days before recovery commences, on average?

Jeff Pietsch CFA said...

I'll take this back further this week if we see further pullback.

Bill Luby said...

Hi Jeff,

That's not how I read it, although I must confess that I found the x-axis to be a little confusing.

I think the best interpretation is that the average of all 37 drops of 3.2% or more is -5.01% and that the bounce begins the first day after the drop. Of course all this data is normalized, so this retracement references the mean bounce, not all bounces.



Anonymous said...

Funny how he posted this analysis when the market was up in the morning... before it went down further in the afternoon.

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