What To Look For From The Key Reversal Day

Posted At 8:45 AM EST

Good morning...We begin the day with flat pre-market futures, as traders recovery from the big reversal following the FOMC statement.  The initial thrust was a clear celebration as the FOMC seemingly gave traders everything they wanted, but as I so often remind our little ones, sometimes we need to be careful what we wish for.

Yesterday's FOMC session was unusual.  We got the typical drift higher before the announcement, but it was more volatile than it typically is.  After the release of the statement, we got some whipsaws, but they were relatively contained, and all in positive territory.  We got the typical trending move into the close, but it was more prolonged than usual.  In short, it was only the second time the S&P spurted to a multi-month high on the day of a FOMC decision, then ended up closing in negative territory.

That reversal carved out what has become a mystical symbol in technical analysis - the Key Reversal Day.  We've studied this pattern many times over the years, and almost always came away empty-handed - there just isn't a lot of consistency in these patterns.

But it's an event upon which a surprisingly large number of traders base their decisions, so let's look again.  There is one piece of information that should help us determine just how important yesterday's reversal really was.

What we're looking for are four qualities:

1.  A gap up open (indicating enthusiasm among "dumb money" pre-market traders)

2.  A new multi-month high (here we're looking at six-month highs)

3.  A close below the prior day's low (uh-oh)

4.  An increase in total composite NYSE volume (showing increased participation)

Going back to the inception of S&P 500 futures, there have been 19 other days that the index carved out one of these Key Reversals, the last one being October 11, 2007.  That's a date that will live in infamy; it marked the high of the last bull market, and the descent into one of the worst bear markets in history.  Talk about a bad sign.

But it's not quite that easy (or bearish).  The table below shows all 19 prior dates, and instead of peeking at the usual performance in the S&P over the next week or month, let's look at how long it took to make it back to a new six-month high, and the drawdown the S&P suffered in the process of getting there.

For the most part, it wasn't that bad...with the last instance being one glaring exception that still hasn't clawed back to a new high, and won't anytime soon, taking a nearly 60% haircut in the meantime.

When we look at the others, we see that on average, it took the S&P 16 trading days to clamber up to set a new six-month high, losing -2.4% at its worst point between the Key Reversal Day and the day it set the new high.  11 of the 19 occurrences managed to set a new high within two weeks, and 7 of them within one week.  More than half of them lost no more than 2% before setting a new high, including 7 that lost no more than 1%.

So how might this help us today?  Well, there has been something of a pattern among the precedents.  When the S&P showed short-term follow-through to the downside (by showing a negative return 3 days after the Key Reversal Day), then on average it took the index 26 days to recover to a new six-month high, and it suffered an average drawdown of -3.8% in the process.  This is not including the outlier from October 2007, which would skew the numbers significantly to the downside.

But if the S&P reversed course and showed a positive 3-day return, then it took the index only 4 days on average to reach a new high, and a drawdown of -0.5%.

These results weren't terribly different if we even looked at 1- or 2-day forward returns; the basic principle held up fairly well.  That's definitely something to watch here, given the modestly optimistic state of sentiment - if the market shows downside follow-through in the coming days, then we probably haven't seen anything nearly as dramatic as October 2007, but it should take the index a few weeks or so to reach another new high.

Bottom line - Intermediate-term Outlook: Neutral (since April 9, SPX 843)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested a new bull market.

During mid-April, the market held up extremely well in spite of being overbought.  This is very rare during an ongoing bear market, and added to the idea that "this time is different" in terms of bear market rallies, as we reiterated in early May.

On July 10th, we looked at a number of short-term oversold readings, and like a good market does, it responded by rallying strongly.  The rally since then has been remarkably persistent, rolling over a multitude of indicators and studies that argued for a pullback.

As we discuss ad nauseam, a market that does not respond to short-term extremes usually has more work to do in the direction of the extreme, and that held true this time as well.  Given how well the market has responded to overbought conditions, it does bode well for the coming weeks (see here and here as well).

We've seen some periodic bouts of excessive optimism during that time, and the market has pulled back in the very short-term after them.  But each time, the major indexes have held technical support, and rallied from even intraday oversold readings, so we've seen little change in the uptrend's character just yet.

We'll be watching closely at how the markets recover from the Key Reversal Day on Wednesday.  As noted in the comment above, the short-term follow-through (or lack thereof) should give us a good clue as to just how important the reversal was.

Bottom line - Short-term Outlook:  Neutral (since July 23, SPX 955)

Last week, on Thursday and Friday, we looked at a couple of shorter-term warning signs.  Both had reached levels that preceded choppy conditions (at best) for the S&P.  Given Friday's narrow range and typical post-expiration behavior, the same seemed likely to be on tap this time around as well.

That outlook seemed far too cautious yet again as stocks jumped higher in the aftermath of the FOMC decision, but by the close bears finally had something tangible to point to as a change in the market's character.  A Key Reversal Day holds magical powers for some.

As we noted above, though, often that magic is nothing more than an illusion.  Key Reversals haven't been much of a key to the downside; more often than not, they just opened a door to a new high a few days later.  What has been pretty effective, however, is watching how the market reacted after the Key Reversals; when we saw additional short-term follow-through, then there was quite a bit more meat to the bears' arguments.

Our shortest-term guides are mostly mixed in neutral territory as the S&P wanders around between 1060 and 1075.  If we fall through the lower end, I'll be looking at a target of 1035ish, with an approach towards there that's accompanied by some short-term oversold readings to most likely lead to another bounce attempt.

It will be an interesting battle here for sure - while Key Reversals have led to short-term weakness about 60% of the time, poor reactions to FOMC decisions have led to bounce-backs about 75% of the time.  Which one wins should tell us a lot about our longer-term prospects.

All the best,