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Reversal of Fortune?



Friday's turnaround was quite dramatic, and certainly seems like it put an exclamation point on the rally (heck, it even LOOKS like an exclamation point on a daily bar chart of the S&P). But did the market actually suffer a key reversal day? Maybe not. I looked at all instances in the past 40 years where the S&P 500 met the following conditions:

• Closed more than 1.5% below its high for the day

• Closed within 0.5% of its low for the day

• Closed on volume 20% or more above its monthly average

• Rallied at least 5% over the prior 30 days

The results suggest that these types of days did not necessarily lead to further weakness in any period from 1 to 20 days forward. In fact, overall, they lead to a bit more POSITIVE action in the S&P than a random period. The only unusual weakness I found was that the high of the reversal day was exceeded in the next five trading days about 56% of the time. This compares to a random day of 80%. So while it did not necessarily lead to further market weakness, it also didn't lead to an immediate rebound in a large number of cases. Some other factoids:

• If the day following the reversal day is down by 0.2% or more, then there is only a 33% chance that the high of the reversal day will be exceeded over the next four days.

• If the market is lower by 0.5% or more three days after the reversal day, then there is only a 9% chance that the high of the reversal day will be taken out in the next two days.

• If the day following the reversal day is up by more than 0.5%, then the market was higher every single time five days later, with an average return of 3.7%.

• Also, in these cases, the high of the reversal day was exceeded 93% of the time within five days.

I left a few things out of this study, such as where the market opened on the reversal day (always a tricky variable because of how cash indexes like the S&P 500 are opened), and how extended sentiment was at the time. If we include too many variables, then the sample size gets so small as to render the results statistically meaningless.

While these statistics are interesting, and potentially useful, they are NOT meant as the basis for some type of trading system. The odds of future market performance are taken in a vacuum and do not consider other, perhaps more important variables.

So what can we take from this? I think the most important factor is that if the market reverses course immediately (again), and we begin to head higher (again) early next week, then there is a very good chance that Friday's reversal will not prove to be all that important. Follow-through, it seems, is everything.

No positions in stocks mentioned.

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