By: Steve Smith
This Thursday morning the S&P 500 Index was down over 1.5% and broke below the 200 day moving average. If it stays down and Friday follows up with more selling, this could be the prelude to a 2018 recession.
As you can see, the SPX has touched or breached the 200 dma on several occasions since the February volatility related collapse but in each case the index has quickly recovered and never close below it.
A common adage in technical analysis states that the more times a support level is tested, the more likely it is to finally give way. And with no major support until the 2500 level, or another 4% lower, this could set up for down day on Friday.
Which in turn, could lead to a very ugly Monday, as Larry McMillan explains in his piece here.
One of things I’ll always remember about the Crash of ‘87 (actually, I’ll always remember everything about the Crash of ‘87 – at least from my vantage point) was that the market was down on Wednesday, Thursday, and Friday of the week before, with Friday being the worst day. That Friday, October 16th, saw the Dow drop 110 points – the largest point drop in history up to that time. Of course, Monday was the Crash.
On that Monday, the futures opened down about 20 points (roughly equivalent to 120 points today, by my estimate). So I learned to respect a market as being potentially extremely bearish if there is a big drop into a closing low on Friday. Another notable (bad) memory came in August, 2015, when $SPX opened down 100 points on Monday after an ugly close to the week before.
Some research out of Schaeffer Investment Research last week pointed out that on the six previous occasions that the market had closed down at least 2% on Thursday and 2% on Friday, it was higher a week later, except for the Crash of ‘87. Well, yes, but you could be run over in the meantime.
In that August 2015 situation, the market opened down 100 points on Monday. Yes, it closed the week with a gain of a couple of points, but you probably had been stopped out for a big loss if you bought on Friday, and the market was crashing on Monday.
This past week, for the second time in the now seven occurrences of -2% moves on both Thursday and Friday, the market was up on Monday (the other was October 1974, and while I was trading then, I don’t remember that move specifically).
But whether up or down, the six occurrences that don’t include the Crash of ‘87 saw a 2.5% move, on average on Monday. So, it seems to me that buying a straddle on that Friday close is probably the best strategy. Moreover, since it is likely that the front-month $VIX futures would be trading at a big discount on that Friday close, the ultimate strategy would be: buy “the market” and buy “volatility” – our VXX/SPY call hedge. The complete data is in the table below.
Some further notes: the 1974, July 2002, and 2009 occurrences were during a heavy bear market – even near the ends of those bear markets. 1987, Aug 2002, 2015, and 2018 were not ongoing bear markets at the time they occurred, although $SPX was off its highs by the time these moves happened.