Will U.S. stocks lurch lower from here? Look to past ‘waterfalls’ for context

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Will the U.S. stock market take another dive down? Go chasing waterfalls to find out the answer.

As sharp as the March downturn was, the rebound of the past few weeks has been perhaps just as head-snapping. Many analysts think markets are likely to try to find a fresh low as the reality of pandemic-scarred economic and corporate data starts to hit home.

A new analysis from Ned Davis Research offers some historical context for understanding how likely that is in our current situation. There’s a lot about the world now that feels unprecedented, but the suddenness of the market dive in March, an event called a waterfall, has precedent.

And while we’re not out of the woods in terms of retesting earlier lows, the Ned Davis analysts say, the rally of the past few weeks “increases the chances that any retest would be less severe.”

Just as it can be tricky to define “bear” and “bull” markets, “there is no single definition of a waterfall decline,” Ned Davis analysts Ed Clissold and Thanh Nguyen wrote, “but most include weeks of persistent selling, no more than two up days in a row, a surge in volume, and a collapse in sentiment.” Waterfalls are usually thought of as one phase of a bear market.

The collapse in financial markets —a 37.1% decline in the Dow Jones Industrial Average DJIA, 2.30% — from mid-February to March 23 clearly constitutes a waterfall, they noted, but added that “picking a waterfall start dates is a subjective exercise because waterfall declines often begin with a trickle.”

Assuming a start date of February 12, the recent waterfall event was the largest in history, even though its duration was only average. And the rally has matched the downswing: the 30.4% surge from the low on March 23 to the close on April 17 is the biggest on record.

DOW JONES INDUSTRIAL AVERAGE WATERFALL DECLINES
Start date End date # of calendar days % change in DJIA
10/10/2029 10/29/2029 19 -34.8
8/14/1937 10/18/1937 65 -33.8
5/9/1940 5/24/1940 15 -23.1
8/14/1946 9/10/1946 27 -18.4
9/3/1957 10/22/1957 49 -13.7
4/23/1962 5/28/1962 35 -16.9
4/9/1970 5/26/1970 47 -20.4
8/7/1974 10/4/1974 58 -26.7
10/2/1987 10/19/1987 17 -34.2
5/17/2002 7/23/2002 67 -25.6
8/28/2008 10/10/2008 43 -27.9
7/7/2011 8/8/2011 32 -15
11/8/2018 12/24/2018 46 -16.8
2/12/2020 3/23/2020 40 -37.1
Source: Ned Davis Research

Past waterfalls show that “the bigger the retracement, the less severe the retest,” the analysts wrote. “Five of the six most severe retests happened after below-average retracement rallies. Three of the four mildest retests occurred when the retracement was above average.”

If that pattern holds, it means good news and bad news. The glass-half-full perspective is that the retest of the lows will be “less severe.” The glass-half-empty view, of course, is that there’s still a step down ahead of us, no matter how severe it might be.

Ned Davis Research recently upgraded its outlook to neutral from cautious, though, citing other quantitative factors that Clissold and Nguyen call more important than the historical pattern analyzed here.

“Specifically, breadth thrusts were registered by the percentage of stocks above their 10-day moving averages and by a double 10:1 up day,” they wrote. Investor sentiment remains deeply pessimistic, they said, adding that they count that as a “bullish contrarian indicator.”

And finally, at least in the U.S., the monetary and fiscal policy response has been “unprecedented.”

One possible gray cloud? “The Fed may have taken the worst-case scenario off the table, but in doing so, it could have pushed the market to overshoot, setting the stage for an eventual pullback,” the analysts wrote.

Originally Published on MarketWatch

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