Buckle Up...

Written By Briton Ryle

Posted January 20, 2016

Can you hang on for another week? How about two?

Let me put it this way: If the Dow falls 500 points tomorrow (or today), will you freak out and sell everything?

I hope you answered “yes” to the first questions and “no” to that last one about freaking out and selling everything. Because at this point, selling everything on a big down day will be very much like closing that proverbial barn door after all your horses have run away.

Now, I know, I’m the one that brought up the potential for recession in my Monday article for Wealth Daily. I’m not abandoning that possibility. Recent economic data has been really bad. It suggests that the U.S. economy is much closer to a recession than it was just a couple months ago. And if things continue like they are, then we really will see a recession. 

The point I want to make today is that stocks are not going to be a one-way street to lower prices. The market just doesn’t work like that. There can be sharp rallies in even the worst bear markets. In November 2008, the S&P 500 rallied 17%. There was a 9% rally in January of 2009…

I’ll bet there were plenty of people calling market bottoms on each of those rallies. They were wrong. And there are a lot of reasons they were wrong that we aren’t going to get into today.

Instead, I want to talk to you a little more about the nature of rallies and sell-offs. Because both rallies and sell-offs behave in some predictable ways. Wise people will say that while history doesn’t repeat, it does rhyme. And this is true because always, at all times, history is made up of people and their actions. We may have different technology or speak different languages, but human motivations are pretty similar across the ages. That’s why Shakespeare plays can still resonate today… especially the tragedies.

How to Avoid Your Own Tragedy

On any given day, stock prices might be higher or lower. And if you just watch the day-to-day gyrations, you might conclude that stock price movements are completely random. But to simply dismiss stock price movement as completely random and impossible to anticipate or even predict is naive.

Of course, there is some logic to the way stock prices move. The stock market has a rhythm. If stocks rally for five straight days, investors get nervous that the next move will be lower. They will say the market is “due” for a pullback.

Likewise, when stocks have sold off for a few days, investors start looking for a bounce or a “relief rally.”

The exact timing of pullbacks and relief rallies can vary. But even the novice investor is aware of the concepts. Because again, this is human behavior we’re talking about. It is somewhat predictable.

So I thought today we could take a quick look at one pretty simple way to measure and predict the human behavior that drives stock prices higher and lower. 

This particular way of looking at the stock market is rooted in the idea that when price movements get too extreme in one direction or the other, there’s going to be a move in the opposite direction. You can think of it as a rubber band pulled too tight — you know it’s going to snap back at some point. Or you could look at it from a physics perspective: for every action, there is an equal and opposite reaction.

Whichever example you like, the point is that the more extreme a price movement is, the more likely it is to reverse and go in the other direction. So if you have a consistent way to measure extreme stock price movements, you can get an idea when a rally or sell-off is getting extreme…

The simplest way to measure this is with a formula called the Moving Average Convergence/Divergence, or MACD. Don’t worry, you don’t have to calculate a thing. Pretty much any website that can show you a stock chart can also show you the MACD indicator (you will find it under “indicators”).

Here’s what it looks like:

spx macd 5 year small

The larger top section of this chart is the S&P 500, going back five years. That’s the red line. The blue line is the 200-day moving average. The MACD indicator is the smaller section at the bottom of the image.

The first thing you should notice about this image is that the movements of the S&P 500 at the top and the MACD indicator at the bottom look very similar. The peaks and valleys line up pretty well. There is a very good reason for this, and it’s one we have already discussed…

It’s the fact that stock prices don’t like extreme movements. And the MACD measures extreme movements in a very simple way. The MACD indicator measures how far stock prices have strayed from their “average.” And in this case, the “average” is the moving average over the last 200 days. A moving average smoothes out extreme moves. That’s why the blue line in the top of the image is so, well, smooth.

Another thing you might notice about the MACD indicator itself is that it has spent the most time above the little squiggly blue line that runs through the middle. Most times it has dipped below that squiggly blue line, it has quickly moved back above it.

This is because the S&P 500 has been in a bull market for the last five years. Nearly all the extreme moves have been to the upside. Buyers have stepped in quickly when the MACD has moved below the midpoint — they are quite literally “buying the dip.”

The Big Takeaway

Now, as I said earlier, it’s nearly impossible to predict what the market will do from day to day. But it is absolutely possible to put the odds in your favor by using an indicator like the MACD. The further it moves away from the midpoint, the more likely it is that a move in the opposite direction is coming.

There’s one more thing I want to point out: Notice that the MACD has moved very far below the blue squiggly line that marks the midpoint. It’s farther than it was when the market made a short-term bottom on August 24. In fact, it hasn’t been this low since 2011. That means we have not seen a downside move this extreme in four and a half years.

Think about that: We haven’t seen a sell-off this bad in four and a half years…

The odds are getting very high that we see a sharp rally higher in the near future. My guess? Next week. There’s a Fed meeting, Apple reports earnings, and Mercury will no longer be in retrograde.

Now, I will leave you with a quote:

Wharton professor Jeremy Siegel once said, “Volatility scares enough people out of the market to generate superior returns for those who stay in.”

Get ready for some superior returns… at least for a little while.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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