Some times when conducting historical analysis a small sample set can tell you that the market is doing something extraordinary. Indicators reaching excessive readings often suggest an edge because when things get too extreme, mean reversion tendencies tend to kick in.

There are other instances where a small sample set simply suggests the market is not acting as it should. Monday’s action may be a good example of this. Gains of 3% – 4% that occurred on Friday were given up Monday in all indices on an intraday basis and most on an end of day basis. The S&P 500 rallied over 4% on Friday. After dipping below Thursday’s close late in the day Monday, it barely closed above it. I ran a test to find other times since 1975 that the market had gained at least 4% one day and then printed a low below the close of 2 days ago.

Today was the first.

I loosened the requirements to 3.5%. Still nothing.

3%. Nope.

2.5%? Yes – two instances. Even at 2% there have only been 6 instances in the last 33 years where the market has given back all its prior day gains.

Now, in case you interested, all six of these did bounce above the selloff day’s close within 2 days. In fact, 5 of them managed to bounce the next day. The bounces did tend to die out after day 3. So perhaps there’s a small upside edge based on this study, but that’s not the real takeaway.

What’s significant here is that the market is acting in a way that it shouldn’t. It especially shouldn’t if it is planning on launching a great bull move. Look at some of the charts I’ve posted in the blog the last few days. Look at periods like March ‘03, July & October ’02, September ’01, September & October ’98, November ’97 and any other bottom you find. Massive one-day gains coming off lows simply don’t get wiped out the next day. It doesn’t happen. It happened Monday.

I would consider Monday’s action a warning sign.

If nothing else traders should still be operating under the assumption that the market environment remains extremely choppy. Look to take advantage of the chop. As an example, the incredibly simple system I published for shorting a few weeks back has had 4 trades since. Here they are (all trades based on SPX closing prices):

Short 8/27 – cover 9/2 – 0.32% gain
Short 9/8 – cover 9/9 – 3.41% gain
Short 9/11 – cover 9/15 – 4.43% gain
Short 9/19 – cover 9/22 – 3.83% gain

That’s 12% from just the short side in a little over 3 weeks. All based on an incredibly simple system. Playing the chop has been working. Monday’s action suggests that despite last week’s bottom attempt, this hasn’t yet changed.

The kind of price action we’ve seen in the S&P over the last two days has been found almost exclusively in one type of place – bottoms.

I looked at any time the market closed up by at least 3% today after being down over 1.5% yesterday. Both days had to have at least a 3.5% range. There was no criteria stating the market had to have suffered a significant selloff – but it always did. I don’t have charts of the 1st 3 instances. The rest I do.

The first was 10/24/62 and it led to a major bottom and an immediate rally. The 2nd was 11/26/63 and the story was pretty much the same there. A big rally ensued. The pattern also appear on September 5, 1974. That was the lone disappointment. The market made two more legs down before bottoming out a month later.

The next 6 instances are all shown below. I’d suggest studying them.

After gapping down Tuesday morning the market put in a sizable rally. The S&P gained over 4% from open to close. I looked back at other times the SPY gapped lower and then gained over 3.5% from open to close.

The low number of instances means this is more “interesting” than “significant”. The pattern was fairly consistent as 5 of the 6 closed below the entry point within the next week before launching higher. The six instances occurred on 10/28/97, 10/15/98, 1/3/01, 7/24/02, 3/17/03, and 1/23/08. Some significant bottoms in that mix. The only instance that didn’t pull back within the next week was 10/15/98.

Below are a couple of tests I showed in Thursday night’s Subscriber Letter. They provide a nice example of why it’s dangerous to quickly jump to conclusions without solid evidence and a decent sized sample set.

When the market makes a large gap lower and then reverses strongly that is normally considered bullish. In fact, the evidence is unclear. Testing on the SPY using Thursday’s action would agree with the bullish assumption:

The number of trades is very low but the stats are suggestive of bullish implications after a short pullback. Eight of nine instances closed lower at some point in the next 3 days by an average of ¾%. Looking out 10 days every instance had at least 1 close higher. So pretty good stats, but not entirely convincing. I tested on the NDX as well. Here we see a large discrepancy with the SPY results.

Results here suggest quite bearish implications. The take away is that the setup does not clearly suggest an edge either way. Someone accepting the low number of instances and only checking either the SPY or the NDX might be led to believe otherwise.

When a move that is already becoming extended rapidly accelerates it frequently means a countermove is about to begin. I discussed this concept in April in the context of an intraday timeframe. Tonight I will finally show its historical effectiveness using daily bars.

After trading lower for three days in a row, the S&P 500 (and most everything else) completely collapsed today, finishing down about 3%. Below is a study that shows the short-term statistics following similar setups:

The edge erodes after the 1st week. It’s basically a short-term setup. To give some perspective on how often any kind of bounce above the entry occurred I ran a 2nd study that looked to exit any time the trade closed profitable.

Pretty impressive reliability. Here we see 81% winners within the next 2 days, 89% within a week and 96% within 8 trading days.

Today’s drop was not only the biggest of the move down, it was over twice the size of the next biggest drop (last Friday). Generally, the more extreme the drop in comparison to the other days, the better the results. Below are the stats associated with a 2x drop similar to today:

Better winning percentage, higher average wins and lower average losses make for better overall stats. I also ran the “1st profitable exit” strategy here:

Thirteen of fourteen were positive within 3 days. By day 8, all fourteen instances were positive.

This all suggests a reflex move higher is likely in the next few days.