Technical and fundamental analysts are wasting their time in the search of an indicator that will forecast the magnitude of a correction.
It’s already hard enough to forecast the market direction, or what quants may call the sign of the return in a forward period. Trying to find a pattern, or fit an indicator on charts to forecast the magnitude of a correction in addition to the sign is an exercise in futility. The same holds for any fundamental analysis.
We can know in the context of probability the direction of the market but we can never know the size of the moves. Measuring moves was an unsuccessful practice of early technical analysis and when people thought they had found a lossy compression of price action. The lossy compression in the form of chart patterns and its evolution to using indicators ended up, in my opinion, facilitating a massive wealth transfer from uninformed technical traders to professionals. Similar fate had attempts to forecast markets with fundamental analysis.
However, both technical and fundamental analysis, besides offering a probability of direction, usually may provide some sense of the risks. This is extremely important and can make the difference between a reasonable return and uncle point. Let us look at a chart below of the S&P 500.
The chart shows the S&P 500 (log scale) and the drawdown profile of the index along with some statistics. It also shows the 200-day moving average.
First observation: Price is below the 200-day moving average. This means risks of a larger correction have increased.
There is no way to know how far this correction will reach. Those who try are wasting their time while some momentum traders just get out when price crosses below the 200-day moving average and wait to get in again when it crosses above. There are certain risks with this simple strategy and the worst arise from an extended sideways market but that is beyond the scope of this article.
The above simple strategy has generated a Sharpe of 0.64 vs. 0.55 for buy and hold in the case of SPY ETF total return since inception. So far, focusing only on the sign of returns and refraining from forecasting the magnitude has paid off in the form of better risk-adjusted returns. But again, caveat emptor: we don’t know if in the future this strategy will continue to work.
Second Observation: Current drawdown of S&P 500 from all-time highs is 9.3% and this is just above the long-term average of 9.8%.
If the index will drop more below the average, then the probability of a correction towards one standard deviation of the available sample will become higher. The one standard deviation away from the mean is at about -20% and coincides with the definition of a bear market.
In the past when the index dropped 20%, on some occasions it rebounded and on other occasions a bear market started. This is the point when usually exposure is further reduced to diversify and/or preserve capital.
There are ways of fitting the above two observations in a systematic strategy and in fact many have been doing this for a long time. But trying to predict how far markets will drop using any methods is an exercise in futility.
Disclaimer: No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.
Charting and backtesting program: Amibroker. Data provider: Norgate Data