Killing Conventional Wisdom... (Part 5)

Let's keep building upon the knowledge we have gained over the past few months. As you know, we recently learned that it was better to buy 10-day lows versus 10-day highs in the S&P 500. We've seen that buying the market on pullbacks has historically outperformed buying the market after it has risen 3 days in a row. We also now know that buying a market that closes in the bottom 1% of its daily range is better than buying it after it has closed in the top of its range. And last week we learned that since 1986, whenever the VIX ($VIX.X | Quote | Chart | News | PowerRating) has closed 5% or more below its 10-period moving average, stocks have moved into a dead zone. The upside edge that has been prevalent over the past two decades in equities has existed when the VIX was 5% or less below its 10-day MA (we saw that played out again this past week as the markets essentially did nothing after the previous week's big gains). We are learning to think counter-intuitively. And, this counter-intuitive thinking is backed by facts and statistics, not others' guesses and opinions.

This week, let's go further. Let's look at what the market does after it has a big move to the upside and a big move to the downside.

Who In Their Right Mind Buys The Nasdaq After A 4% Drop?

Conventional Wall Street wisdom states that after a market has a big move up, it's a great sign that the market will continue higher. "The market looks great," "It's a breakout," "Today's explosive move was fueled by great earnings, improving economic conditions" (and feel free to add anything else here that the media and analysts spout after these big up-days). And when the market has a large one-day drop, it's all panic. "Poor corporate earnings," "Investors fear worsening economic conditions," "Buyers are nowhere in sight" are the pained words of wisdom broadcast after the drop.

So what should you do after days like this? Should you immediately buy after the market has a big one-day move and everyone is jumping up and down? Will you be instantly rewarded with riches? And should you be selling after the market takes a big one-day hit because you're told that it's the end of the world? Will a generation of wealth soon be lost because the market got hit today? Well by now, you probably know the answer. The answer is this: there is no edge in buying after a big up-day. And, when the market has a big one-day drop, you definitely should not sign up for the membership in the "world's-coming-to-an-end suicide crowd." In fact, after a big one-day drop, historically you should have been a buyer after these big down days.


Let's Look At The NASDAQ 100

On a percentage basis since 1985, the Nasdaq 100 (NDX | Quote | Chart | News | PowerRating) has had more large daily percentage moves than the Dow and S&P, so let's focus on that market. Over the past 19 years, the average daily gain for the NASDAQ 100 has been .07%. The average weekly gain has been .34%. The average monthly gain has been an impressive 1.41%. So, how has the market done after the periods that the Nasdaq has had a "great, great, great day" and risen 4% or more for the day? Shouldn't a big move like that lead to a further big move? Well, sadly it has not. In spite of the fact that most of Wall Street has their "happy helmets" on after a day like that, the follow-through (on a net basis) has not occurred. The one-day returns were not any better than any other regular market day and incredibly, had you bought after these days and held one week or one month, you would have lost money (minus .15% for the next week and minus 2% for the next month)! In fact, the NASDAQ was lower 60% of the time a month after these moves. Wow, big up move, everything looks great, and the returns over a week and over a month are negative.

Things Look Bad? Time To Buy!

If the Nasdaq 100 can't make money after a big move, you would think it would get killed after a bad, down move. That's what we've been taught. Well, it's wrong. When the Nasdaq 100 has lost 4% or more for the day (and the world is many times supposedly coming to an end) the averages rose .51% the next day, an impressive 1.42% for the next week and an equally impressive 1.77% for the next month. The times after the Nasdaq 100 has been hit 4% or more, have outperformed, on a net basis, the average of all days over the past 19 years, and especially have outperformed the weeks and months following a big up-move.

How To Use This Knowledge...

As I stated last week, there is no assurance that these results will be true in the future. But, from these results, we have learned something new which you may be able to use for years to come. These are:

1. There has been no edge in buying stocks immediately after a big move up. Yes, there are a million reasons to be a buyer after a day like that. It's played out by the press each evening it has occurred. But, at least over the past almost two decades, it's led to losses over the next week and month on a net basis.

2. Big moves down are scary. So are 10-day lows, 3 days down in a row, and markets that close in the bottom 1% of their range. They all have led to gains and outperformance over the past 15-20 years. We've see this theme over and over again.

3. None of this means that every trade or any trade will be profitable. Not even close. That means risk controls, risk parameters and prudent portfolio management rules need to be adhered to to fully take advantage of these potential edges (you can find a number of lessons on this in the University section of www.TradingMarkets.com).

4. I say this often and it's so important: You need to drown out the emotion that the media brings to you during these times. The media reaction to these days is after the fact, not before. And, as we have seen week after week, this emotion is usually wrong. And in many cases, it's very wrong. Rely upon your own wisdom. Look at the market as it is, not as it is supposed to be. Blindly buying after a big up-day, on a short-term basis, more often than not, has led nowhere. And buying after big down days has led on average, to outsized short-term gains. Somehow, a mentality has taken over that says that buying always begets buying and selling always begets selling. If that were true, the averages would be either at zero or at some astronomical number. But we know that's not true. Instead, the stock market trades from overbought to oversold to overbought over and over again, and over the decades it has slowly but surely trended higher. The real opportunity is knowing when there is an edge, and acting on that edge. And as we've learned this week, there has historically been much more of an edge in buying the Nasdaq after it has dropped significantly, versus buying it when everyone is excited because it has risen significantly.

Have a great week trading (and feel free to email me any questions you may have to lconnors@tradingmarkets.com).

PS- Later this week we're going to be releasing for the first time a trading module on how to trade the mini-sized Dow. John Carter, who is a professional money manager and trader, is the author. If you would like to read more information about John's mini-sized Dow trading course, you can find it at www.tradersgalleria.com.