7 indicators: the worst in the stock market may not be over

Price crash and bear market

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We will look at 7 technical indicators, bearing in mind the limitations of technical analysis and the fact that it is more of a descriptive than a predictive method. Ultimately, prices are determined by fundamental factors, but technical analysis, if done correctly, can help some extra context.

A lack of extreme moves can be a sign of a bear market in the early stages.

We start with a chart of S&P 500 (SPX) daily returns since about 1995.

S&P 500 Daily Chart with Daily Returns, Standard Deviation and Average Absolute Deviation Bands

S&P 500 daily chart showing daily returns, standard deviation and average absolute deviation bands (Price Action Lab Blog – Norgate Data)

The top daily return chart shows the +/- 5 standard deviation bands. The bottom daily returns chart (identical to the first) shows the +/- 8 mean absolute deviation bands. During the past two major bear markets, and even during the 2020 pandemic crash and the 2011 correction, daily returns exceeded the thresholds set by the bands. This year, however, all the action stayed within those thresholds. The market’s decline has been exceptionally smooth and has been referred to as “a slow pain trade”.

The lack of volatility extremes can also be seen below.

S&P 500 Daly Chart with 21-Day Annual Volatility and 14-Day ATR %

S&P 500 Daly Chart with 21-Day Annual Volatility and 14-Day ATR % (Price Action Lab Blog – Norgate Data)

The horizontal red dashed lines show extreme levels of volatility, the 21-day annualized ATR and the 14-day ATR as a percentage of the closing price, during past bear markets and major corrections. The S&P 500 index has not yet reached these extreme levels this year. It could be a regime change or an indication that we are almost at the beginning of a major downward movement.

The 252-day z-score indicator also confirms the lack of extreme moves.

Daily S&P 500 Chart with Z-Score Indicator

Daily S&P 500 Chart with Z-Score Indicator (Price Action Lab Blog – Norgate Data)

In most past bear markets and major corrections, the z-score indicator has crossed the lower standard deviation band of -3. This hasn’t happened this year, at least not yet. This is due to the orderly correction, and as mentioned before, it could be a regime change, but the chances are slim. The scenario whose worst we haven’t seen yet has a higher probability.

The indicator of price’s distance from the 200-day moving average in percent also offers a similar perspective as above.

Daily S&P 500 chart with distance from 200 day moving average

Daily S&P 500 chart with distance from 200-day moving average (Price Action Lab Blog – Norgate Data)

In both past bear markets and during the pandemic crash of 2020, the distance from the 200-day moving average fell below -25% (red dashed line). The distance currently stands at 10.8% after falling to about -16%. The current value may be the bottom, as in 2011, 2015, 2016 and 2018, or there is significant downside potential.

The lack of strong relief rallies has surprised many traders this year. This phenomenon can be seen below.

S&P 500 Daily Chart With Big Daily Returns

S&P 500 Daily Chart Showing Major Daily Returns (Price Action Lab Blog – Norgate Data)

The top indicator chart shows daily returns above +3%. The vast majority, or 83.74% of those returns, 103 in total, occurred when the price was below the 200-day moving average. Only 20 of those returns occurred when the price was above the 200-day moving average. Note that these statistics are from March 1943. Only one return of more than 3% has occurred this year, on June 24. The bottom chart shows that no returns greater than +5% have occurred this year, although they have been common during previous bear markets. Note that 21 of the 22 returns greater than 5% have occurred since 1943 when the price was below the 200-day moving average. Some of these took place after a bottom, but most were relief rallies, especially in 2008.

This curious lack of aid demonstrations may indicate regime change or that the real correction has not yet begun.

The 12-month Relative Strength Index shows no signs of being oversold.

Monthly S&P 500 Chart with 12-Month RSI

Monthly S&P 500 Chart with 12 Months RSI (Price Action Lab Blog – Norgate Data)

I have included this indicator although I believe it is unreliable and relies on it working when a bear market occurs; otherwise it may give false signals.

Note that in 1974, 2002 and 2008 the 12-month RSI reached oversold territory (below 30) and marked a bottom. However, in the event of major corrections, for example in 2011, 2018 and 2020, this indicator did not indicate a bottom. It’s a good indicator to check, but it should be used along with other more robust ones. If a bear market develops, looking at this indicator can provide clues about a bottom at risk of false signals.

The last indicator is a linear regression chart of the S&P 500 since the GFC bottom and the start of QE, which set off the longest uptrend in stock market history.

S&P 500 Daily Linear Regression Chart

S&P 500 Daily Linear Regression Chart (Price Action Lab Blog – Norgate Data)

The chart shows the trend and the +1 and -1 standard deviation lines.

Note that some may misunderstand these charts in the following sense: the chart does not say that the S&P 500 will fall about 20% more to -1 standard deviation below trend. The chart says that if the market drops to that line, it will be a very likely bottom, like in 2020 during the pandemic crash.

Note that the post-pandemic stimulus irrational exuberance caused the index to reach the +1 standard deviation above trend, an extreme move. Usually those extreme moves up are followed by extreme moves down.

Conclusion

The lack of extreme moves in a 21% drop in the S&P 500 could mean two things:

  • This is a normal correction to get rid of excesses.
  • The correction is the start of a bear market.

I have discussed 7 indicators above that illustrate this lack of extremes that have been so common in previous major corrections and bear markets. This change in market dynamics could be a new regime, or as they say, “this time it’s different”, or the first stages of a more serious correction and bear market. In my opinion, the latter scenario is much more likely, but I will update my priorities as new information becomes available.

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