The past three or four months may leave an investor waiting for a pullback to get into the market. Is this past week’s market rout the opportunity we’ve been waiting for? According to the positive breadth (the increasing percent of stocks rising) in the S&P 500, yes.
January 31, 2020 marks the last occurrence of our oversold signal according to our model which utilizes the 10-day average of the percent of advancing members within the S&P 500. Values of 60% and 40% are assigned as the overbought and oversold readings respectively. Upon analyzing the signals, we can see whether purchasing the S&P 500 based on this signal improves, worsens or has no impact on the outcome of our chances in the markets.
(Definition of terms: Risk reward ratio: calculated by taking the cumulative win percentage divided by the absolute cumulative loss percentage for all days when the advance-decline volume line is below 40. Unconditional risk-reward ratio: utilizes the same calculation as risk-reward ratio but is taken for every day during the time indicated above the table. Strategy Benefit: the percentage difference between the unconditional reward risk ratio and the reward risk ratio.)
By looking at the row “Strategy Benefit”, we can see that this signal shows it has historically increased your risk-reward ratio of investing in the S&P 500 by double digits looking up to 6 months. However, the impact of the signal shows the most promise and potential value within the first month which is very similar to the time frame you would expect the market to rally based off its oversold reading.
Notice that your hit rate, the percent of positive readings, relative to the unconditional hit rate is unbiased towards this signal which tells us that this signal’s forward returns are still dependent on the direction of the overall market.
In conclusion, and based on historical signals, when the 10-day average of the percent of advancing members of the S&P 500 line is below 40% and a bull market is intact, we see a beneficial risk-reward relationship, above a normal level, going out as far as 6 months. Translated, what this tells us is that the bottom may not be in, but we are in good company for the next 6 months as far as history is concerned.