June Was Down 10% - What's Next?

by: Barry Ritholtz posted on: July 07, 2008 | about stocks: DIA / QQQQ / SPY

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Welcome to a new quarter, back from the long holiday weekend, and to the start of another earnings season.

There are many cross currents going on, and today, we want to review one in particular. What happens after Markets suffer very large 1 month declines?

Several words of caution are due first: Traders can get into trouble when extrapolating. This is especially true when dealing with relatively small data sets, and fifteen examples over 2/3rds of a century certainly qualifies as small. Additionally, the causation/correlation issue arises especially in small samples (random or truly causative?).

Caveats aside, let's have a look at the 15 prior biggest one month Dow selloffs. As the chart below shows, we often see a healthy snap-back after significant one month sell offs 6 and 12 months later. Except when we don't, such as 1973 and 2001, where we see even larger losses one year later.

via Jake

What does this mean for traders? Well, if 13 out of 15 sounds like good odds to you, then you will be tempted to play this sell off for a bounce.

Perhaps adding another layer of questions to your analysis might be helpful. Is the current environment -- high inflation and oil prices, modest growth, large write-downs and profits declining from a peak measure, and relatively low fear levels -- more similar to 1973 and/or 2000, or is it closer to the other 13 periods?

Answer that question and you have your trade.

And speaking of fear: A recent Bloomberg survey of Wall Street strategists shows they have little or none. Instead, for the second half of 2008, they are forecasting the best S&P 500 since 1982.

Whether their analysis is similar to the chart we shown above, or is simply more of their institutional tendencies towards perma-bullishness, we cannot say.

Regardless, here is a quick excerpt (note the unusually skeptical tone of the Bloomberg piece).:

Deutsche Bank AG, Lehman Brothers Holdings Inc. and UBS AG say the Standard & Poor's 500 Index will gain the most in 26 years during this year's second half. That isn't going to happen, if history is any guide.
The S&P 500 will rise 18 percent by January, according to the consensus projection of 10 U.S. strategists surveyed by Bloomberg. The forecasts are based partly on estimates that profits will jump 50 percent in the fourth quarter after falling for the past year.
Even if that happens, it may not be enough. In 2001, the last time profits fell as much, they then had to climb for three straight quarters before stocks rebounded. Analysts' earnings estimates for this year still represent a decline from 2006 levels, making the strategists' optimism harder to justify, investors say.

There verywellmight be an 18% bounce out there somewhere, but I suspect it come from lower prices, more deeply oversold conditions, showing greater levels of fear and panic.

Source:
Deutsche, UBS Fight History Forecasting Best S&P 500 Since 1982
Eric Martin and Michael Tsang
Bloomberg, July 7 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=aTjWQbjpkpxk&