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Upside Ahead?



This article was first published on 07/30/03

We used a combination of classic panic and thrust momentum indicators for the S&P 500 (SPX) monthly chart going back to 1970 to generate a long-term "buy" signal. This long-term buy signal was initiated in June and suggests the SPX could rally nearly 9% over the next 4 months and potentially greater than 30% over the next two years. This signal is not based on theoretical assumptions, but historical precedent since 1970. It focuses on the real returns after a pronounced period of weakness is culminated by climactic selling pressure, which is then followed by a buying panic strong enough to change the long-term thrust of the market. The signal suggests the S&P 500 could see prices of 1075 by early September and 1250 or higher by the middle of 2005.

A Powerful Long-term Market Signal - What Is It?

In a world overly focused on quarterly performance, we wanted to step back and take a longer perspective given all the economic, earnings and geopolitical crosscurrents. In doing so, we noticed a very clear pattern when coupling a selling and buying panic, and a 15-year monthly chart of the (SPX) overlying a 14-period Stochastic Oscillator.

Since 1970, when the SPX encountered action weak enough to cause the overbought/oversold Stochastic Oscillator to cross below 40 followed by a selling panic, and then reversed substantially enough to get a buying panic followed by the oscillator moving back through 40, it has been an extraordinarily accurate signal for further gains - normally significant in nature.
Stochastic Definition. The Stochastic Oscillator is formula based and compares where a security's price closed relative to its price range over a given time period. In this study, it would represent where the SPX closed relative to its 14-month range.

Panic Sell And Buy Day Definition. According to Paul Desmond at Lowry's Reports, (who was kind enough to provide our price and oscillator data as well as the sell and buy panic reports) a selling panic is defined as a 90.0% downside day where downside volume equaled 90.0% or more of the total of upside plus downside volume, and points lost equaled 90.0% or more of the total of points gained plus points lost. A buying panic would be the reverse. In order to suggest an important low is near, there needs to be both within a relatively short period of time, followed by a move to 40 or above in the 14-period stochastic. A short period of time would be considered under 6-months since we are using long-term data.

Longer-term Implications-overbought becomes more overbought: The aspect we found the most surprising was the average gain AFTER the oscillator reached 80 (overbought). Most view an overbought market in a negative way when it is not always the case. In fact, using this indicator, overbought gets a whole lot MORE overbought. The average gain from the generation of the signal to the price peak before the signal was negated by the oscillator moving back through 40 was 54.19% in 26 months. Even If you take out the last signal gain of 230%, the average gain was 28.99%, from initiation to deletion of signal. In other words, most of the gains came after the overbought reading of 80. The worst-case move from signal to price peak was a 15.5% gain in 1981.

As is the case using any indicator, if there is a beginning, there must be an end. We used the first 14-period stochastic move below 40 as the eventual exit point. This produced an average return of 37.86% over 33 months. The worst case was a gain of 3.45% over 16 months and if you take out the best signal performance instance of +183.3%, the average return of the other 7 signals was still 19.93% over an average of 26 months.

Near-term Implications: This signal uses long-term data, but has near-term implications. Each time a signal has been generated by a move in the Stochastic Oscillator above 40, the Stochastic went to 80. That initial thrust in the Oscillator generated an average gain of 8.79% over the ensuing 4 months. The worst-case "initial thrust" scenario was a gain of 3.7% in one month after the initiation of the signal. There has yet to be a negative return using the S&P 500 monthly data after the combination of panic sell and buy days followed by a 14-period stochastic move above 40. There were instances of temporary pause, but the Oscillator went from 40 to greater than 80 every time.

Is the S&P 500 already up too much from the low?

Conventional wisdom holds that when prices are up sharply, the next move should be down. History shows this may not always be the case. The average move up from the monthly low BEFORE the signal was generated was 15.86%. In fact, the market was up the better part of 20% ahead of the initiation of the average signal. In other words, the more the market was up quickly, the more it ultimately rallied. Again, there has yet to be a "bad" signal.

It is what it is.

We, ourselves could come up with countless reasons to explain the returns away and ignore what it says - thinking that it is different this time. Everything in the financial markets changes - EXCEPT human nature. To show this we included a chart that was done years ago and provided by our great friend Harvey Eisen of Bedford Oak Capital Management, LLC. It is the psychology of every market cycle and if you look closely on the left side of the screen, you might see some familiar comments in I, II, and III. Please pay special attention to number III.

In sum, history suggests the strength of this market should be different from the prior rallies over the past four years because there was a sell and buy panic powerful enough to cause the 14-month Stochastic Oscillator to move back above 40 after dropping below it. We would advise those who read this piece and look at the results not to focus on what it is, but instead to focus on what it says. What it says is that at worst there is a small upside from here...and at best...well, a whole lot more.

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