Extremely overextended prices characterized the week ending January 26 and conditions were set up for a sharp downward correction. We can quickly determine this fact by using a couple of twists to common charting techniques. When stock prices meet these conditions, it is a red, flashing-warning signal of an imminent, rapid decline, which investors can then sidestep.
The 50-week (one-year) moving average serves as a pivotal long-term average (or long-term mean) of the market. When conditions become too far extended above that long-term mean, it signals that stocks are ripe for a sharp correction or, as it's sometimes referred to by professionals, reversion-to-the-mean – and that's precisely what occurred.
Chart 1 below shows a weekly price chart of the S&P 500 in the top window. In the lower pane, the Percentage Price Oscillator (PPO), a measure of the percentage movement of prices, is set so that it shows the percentage that the S&P 500 is stretched each week above its 50-week exponential moving average (EMA), a moving average that serves as the market's long-term mean. We can see that the S&P 500 reached a level of 14.2% above this long-term mean during the week of January 26. It has been seven years (January 2011) since the S&P 500 previously extended that far above its long-term, 50-week mean, which is noteworthy.
Chart 1: The week of January 26 saw prices move 14.75% above the long-term mean (50-week moving average), setting up the market for a sharp correction.
Whenever prices stretch too far, too fast above their long-term, 50-week mean, or above their intermediate-term 20-week mean, it is always a prelude to a reversion back to that mean. The force of investor greed regularly pushes prices too high during periods of overexuberance, which occurred in January following the corporate tax reform measure that Pres. Trump signed in December.
Then, as institutional investors began to take profits at that high and prices started to decline, fear took over, and millions of investors pulled the trigger to sell more shares, resulting in prices tumbling back down towards their long-term mean.
Another charting tool that offered investors a warning of the imminent selloff in late January is Bollinger Bands. Created by John Bollinger, these are volatility bands placed above and below a moving average. We measure volatility by standard deviation, which changes as volatility increases and decreases. The bands automatically widen when volatility increases and narrow when volatility decreases.
While most traders apply Bollinger bands to daily stock charts, we use weekly stock prices with the Bollinger bands set at two standard deviations from a 20-week moving average. We consider the 20-week moving average to be the intermediate-term mean of stock prices. Bollinger Bands set to two-standard deviations from their 20-week moving average (mean) should contain about 96%-98% of all closing weekly stock prices. When prices move above the bands, it means they have gone too far, too fast and there is a significant likelihood of reversion back to the mean (and possibly even further). The same principle applies if prices close below the lower Bollinger Band; it signifies deeply oversold prices and can trigger a 'buying panic' that results in a sharp jump in prices.
Chart 2 below shows that prices had closed slightly above the Bollinger Bands the week of January 8 and week of January 16. This was pushing the limit, but then the week of January 22 saw the S&P 500 ETF (SPY) price close significantly (more than 1%) above the upper Bollinger Band. The following week the inevitable occurred, as prices of the ETF plummeted -3.88%. This move was unusual because there had not been a weekly move of more than 1% throughout all of 2017 and into the first two months of 2018 - 14 months of very low volatility.
Chart 2: The week of January 26 saw prices move 14.75% above the long-term mean (50-week moving average), setting up the market for a sharp correction.
Last week (February 4-9) saw even more significant selling, as prices dropped another -5.06%. While overshooting below the 20-week moving average, this may have been merely a case of reactionary overselling. On the other hand, it could mean that this is a more significant, long-term correction that will see prices revert to their long-term, 50-week moving average, rather than the 20-week EMA. In the coming weeks, if prices return higher, it will show that the recent extreme price change was just a technical, reversion-to-the-mean move and the rally should resume.
The bottom line from a review of the above charts is that in a frenzy over the December tax cuts, the market went into a near-parabolic pattern during January. After reaching extremely overextended levels the week ending January 26, the market performed a classic reversion-to-the-mean and returned to its essential, 20-week moving average (an maybe lower, to its 50-week moving average).
By being aware of overextended conditions that technical indicators showed was occurring in late January, investors can prepare for the inevitable, attention-grabbing, fear-inducing, reversion-to-the-mean correction moves. Unlike tha vast majority of investors who can become panic-stricken you will be able to shrug your shoulders, knowing it is nothing more than a price realignment. Remember, as long as the underlying, fundamental conditions remain intact (as they seem to be for now), corrections are merely temporary, technical price adjustments and have little long-term significance.