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Unhinged market tests Wall Street rules of thumb

Michael Santoli
Michael Santoli

We’re moving from an indiscriminate selloff to a discriminating bounce.

After three days of sweeping carnage in global stock markets, overnight Chinese stocks (000001.SS) suffered more injury and Japan (^N225) fell further. But Europe and US stocks were poised to stage at least reflex rallies.

This was even before the widely anticipated easing move from the People’s Bank of China was announced before 7 am New York time. The fact that Western markets were set to de-link from China’s manic market is a positive, if only a tentative one.

With the immediate prospect of an ongoing crash set aside at least for the moment, an investor’s greatest risk is perhaps being hit by an errantly thrown cliché.

In volatility attacks, supposed rules for surviving and profiting from are thrown around both by real and would-be market gurus.

When stock prices start whipping around as wildly as they have in the past few days – the Dow traversing a 1,000-point path yesterday alone – people grasp for the old rules of thumb for some kind of guidance.

“We’re so oversold we have to bounce soon.” This morning we’re hearing that stocks are so stretched to the downside, a rally is almost mandatory. We saw “definite signs of capitulation and panic-type selling,” says technical analyst Mark Newton of Greywolf Execution.

Others, too, point to the surge in the VIX gauge of traders’ urgent rush for downside protection, which briefly ramped above 50 yesterday – a level only ever reached in the midst of intense panics.

The S&P 500 fell more than 2% a day for three straight sessions, a rarity outside the crucible of bear-market climaxes.

When we’ve seen the current combination of a one-week 10% drop in the S&P (^GSPC) and a surge in the CBOE S&P 500 Volatility Index (^VIX) above 40, the S&P on average was up nicely one and five days later, on average, by nearly 6%.

It’s only happened 15 times since 1993, but stocks rose over the next five days 11 of those times. The best gain was 19%, the worst loss almost 8%. So if it’s not a true crash – and no one can say persuasively that it is – then traders usually get a chance to play a rebound.

It’s a little like saying that if you survive the heart attack you tend to feel a lot better a week later, but there it is.

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So we’ll bounce, then. But just when you buy into this likelihood another trading cliché comes flying:

“Never trust the first bounce, the prior low needs to be ‘retested’ before a real bottom is in.”

This is standard trading-desk stuff, an idea that after markets have become unhinged and a cascading decline has been halted, prices need to shuttle back to the low point to test whether there is real buying demand there.

As with most clichés, it has its roots in real-world experience and then gets extrapolated into some kind of ironclad rule. It makes sense not to expect this first move higher to be an all clear. This whole year, US stocks have moved far less than other asset markets, and now lots of pent-up energy has been loosed.

Still, I’ll point out that traders are still awaiting a “re-test” of last October’s low near 1862 for the S&P 500. In that case, the first bounce gave way to a more enduring recovery to new highs.

Just in case that’s too reassuring, a final cliché should tamp down undue hopes:

“Markets never bottom in August.”

Again, it’s true that nasty August market dumps – such as the one in the bear market of 2002, or the 1998 emerging-markets panic that resembles the current situation – stocks lifted only to fall back again in September and October before finally making a reliable bottom.

But then there’s August 1982, which was indeed the ultimate bottom of all ultimate bottoms, the end of a 15-year stagnation in stocks that launched the great generational bull market of the ‘80s and ‘90s.

But then, of course, no one was expecting or predicting such a thing back then. And there were fewer tweeting traders and financial-news outlets to trot out all the old clichés.

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