How would you like to bat and know the field coming up? That kind of insight makes all the difference in baseball – and investing.
How much easier would it be for you to manage a bear market if you spotted it quickly and knew how the downtrend was likely to develop? When a stock market correction starts with a “vertical transgression,” you have a good plan based on historical precedent. It gives you an edge in protecting your capital.
Bear market studies
We have many studies on bear market bottoms. The transit day is our preferred signal for knowing when to re-enter the stock market after a punishing correction. While the signal is present early in every bull market, not all follow-up days work. We wanted to understand what differentiates long and challenging corrections from shorter and subdued pullbacks. Were there factors that could alert us when an impending correction was likely to drag on for months with multiple failed follow-ups?
When looking at failed run-through days, we noticed something about the stock market peaks that preceded them. We know what is typical about a stock market top.
Distribution days of higher volume sales are starting to pile up. You will have some up days, but they will be overshadowed by the down days. The losses are greater than the gains. The main moving averages are rising as a result of the previous uptrend, but the index is falling enough to match it. Eventually, the stock market correction will steepen and may even lead to a bear market. However, the vertical offense is different.
Vertical violation defined
A determining factor of a vertical breach is the steepness of the decline from the stock market top. The number of down days is not only slightly higher than the up days. They are overwhelming. You can see multiple days of selling with just one weak profit attempt. At least one of the days down will stand out among the recent action. It is much bigger than all the days around it. The big down day often approaches a drop of 3% or more.
Finally, the decline isn’t just meandering towards the 50-day or 200-day moving average. It cuts through the line. When you see this signal, you can expect at least a few months of choppy action and possibly a bear market.
Take the bear market of the last quarter of 2018. The break of the 50-day moving average was not uncommon (1). With a drop of 1.8% on October 4, it was deeper than the recent action. But the Nasdaq composite largely went back and forth before that. Still, it was enough for IBD to change its market outlook to “uptrend under pressure”.
On October 10, the appearance was very different. As the index cut through the 200-day moving average (2), the day’s drop was much worse at 4.1%. However, it wasn’t just that day that was concerning. Only one of the previous five trading days was positive. Even that one day was barely over. This is what a vertical violation looks like.
IBD Market Outlook Turned to “Market in Correction” and It Was Midway Through First of Three Down Waves (A).
Bear Market playbook
Once you have a vertical breach, there are certain things to expect from the bear market. The severity of the vertical violation usually takes time to heal. Expect at least a few months before a market rally can erupt again. That means your first one or two follow-up days after a vertical breach are more prone to failure.
At some point in the sale, you should expect a bounce. We started collecting at the end of October and we had a follow-up day on November 7 (3). Nothing seemed unusual as the Nasdaq composite moved back above the 200-day moving average line.
However, just two days later (4), the index closed below its next-day low. This is an early sign of failure. On SwingTrader and Leaderboard, we had light exposure and pulled out quickly. Since progress stalled immediately, it was easy to protect capital. As sales increased, we saw the second wave in the bear market (b).
Another failed run day
On November 28, we received another confirmed rally attempt with a follow-up day (5). This day had a bigger percentage gain and more stocks seemed to make progress after that. Instead of an immediate sign of failure, the Nasdaq composite made progress towards its 50-day line (6). Then it was dramatically rejected with a drop of 3.8% (7). That was the beginning of the third wave in the bear market (C) as sales intensified.
We had three bear waves, a repeating pattern in bear markets, and almost three months of a stock market correction by Christmas. Then we saw a strong rally day from the bottom (8), we were more confident that our next walk-through day would succeed. Why? The historical precedent.
History may not repeat itself, but it rhymes
The vertical violation is visually distinguishable. So it is useful to look at examples from the past. As the saying often attributed to Mark Twain goes: “History never repeats itself, but it rhymes.”
The adjacent table shows 10 examples of vertical violations for study from the Nasdaq composite. Some led to a bear market. Others may have been superficial but still had quite some time before they started to come back.
The samples can be accessed through the modification date function on MarketSmith. Links to stories have been included on some recent dates, some of which are in real time, with highlighted graphs pointing to the vertical violations. Instead, you could look at the April and October 2014 pullbacks. These examples are not vertical violations. The sale is not so ruthless in its seriousness. And the number of down days with no rally attempt comes close to the examples of vertical violations.
The follow-up day that ended the bear market
Armed with the historical precedent, we had high expectations from Christmas (8). In IBD Leaderboard, exposure to the lower end of the bear market was light, only 11% invested. One risk of exposure to light is that a strong stock market rally can quickly leave you behind. To avoid that, we added a double position of the Proshares Ultrapro S&P 500 ETF (UPRO). The triple leveraged exposure to the S&P 500 would help us keep up with the market as we added breakout stocks.
On January 4, the Federal Reserve shifted its stance on tightening rates and the catalyst led to a follow-up day on the S&P 500 (9). Volume was lighter on the Nasdaq composite, so it fell short on that index, but you only need one index to confirm a rally. For January 2020, Leaderboard was up 11.0% versus 7.9% for the S&P 500 due to aggressive buying after the end of the bear market.
The stock market crash of the coronavirus
Understanding what a vertical breach looks like and how it plays out can play an important role in protecting your portfolio during a bear market. With the stock market crash of the coronavirus, we recognized the vertical transgression. SwingTrader ended the first quarter with a 10% gain versus the 20% loss for the S&P 500. The leaderboard was down just 3.2% and far outperformed the S&P 500’s loss.
It played out in real time on IBD Live and our other products as we saw the early warning signs of the coronavirus stock market crash. Frankly, we didn’t know how bad the correction was going to be. And we still don’t know how long the bear market will last. But the historical precedent allowed us to protect our capital.
This article was originally published on April 3, 2020 and has been updated.
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