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 average, 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 the market went into a near-parabolic pattern during January in a frenzy over the December tax cuts. After reaching extremely overextended levels the week ending January 26, the market performed a classic reversion-to-the-mean and returned to its crucial, 20-week moving average.
Take-Away: Instead of price alone, keep your eye on an ETF's or Index's long-term, weekly mean, which is usually the 20-week (100-day) simple moving average. Then we can compare the relationship between the current price and 20-week mean of an ETF in multiple ways. Prices tend to trend around this long-term mean in a ping-pong pattern, back and forth between levels that are 2 standard deviations above the 20-week average ('greed') and 2 standard deviation below the 20-week m.a. ('fear'). The next critical level is the 50-week moving average, but if the ETF drops below that level with momentum, you should sell quickly because it is probably headed much lower.
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 the vast majority of investors who can become panic-stricken in such a drop, 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.
All the rules you need to pay attention to if you wish to become a 100% self-directed investor can overwhelm even the most ambitious investor. Most people can't commit the time necessary to master the intricacies of the many conditions that an ETF's price, fundamentals, and macroeconomic conditions represent. It is a full time career, and it's not easy to learn and master a second, full-time career when you're deeply involved in your primary career. That's where the ETFOptimize team can provide you with almost an unfair advantage.
Our staff includes quantitative-design experts with 50 years of combined experience in building algorithmic, rules-based strategies to select the optimum ETFs for the wide variety of conditions presented by the economy and the market. But their primary purpose is to serve as loss-avoidance machines, mitigating or completely eliminating the significant drawdowns that can devastate a portfolio's performance.
To-date, we've collectively produced 92 of 92 consecutive years of profits, operating live—in real time—with our current six rules-based models. Click the button below to select a low-cost strategy subscription that fits your needs, and you are backed by a double guarantee: 14-days of free access for that model, and once those two weeks end and your subscription begins, your satisfaction is backed by a 60-day, no questions asked, money-back guarantee... See Our Strategy Choices.
Not Yet an ETFOptimize Strategy Subscriber?
Get a Strategy Subscription and Weekly Market Analysis - FREE!
The ETFOptimize quantitative investment strategies have a proven track record of consistently high-performance success over long periods. Our premium model strategies have provided an average annual return of 30.53% since their inception – which is a multiple of more than quadruple (415%) the long-term annual return of the S&P 500, and more than eight times more than the index' return since 2000. The ETFOptimize strategies, collectively, have beaten the S&P 500 in 64 of 66 years (97%)!
The ETFOptimize strategies operate using our proprietary, quantitative financial-analysis programming that has been continuously upgraded and refined over the last 25 years, accompanied by high-speed computer servers and high-quality, point-in-time investment and economic databases. As ETFs were developed and became so incredibly popular, we've adapted our approach to embrace these instantly-diversified products.
Why not look over our strategy lineup now and see which one is the best fit for you? It's actually straightforward and affordable to put a high-performance investment strategy to work for you every week of the year. The ETFOptimize models are available by subscription starting at just $9/mo.
(We even offer a Free strategy for those who would like a long-term trial before subscribing).
Look around the Internet; we don't think you'll find a superior approach to investing – offered at such an exceptionally low cost, and making consistent, high-performance investment results affordable for even the smallest investor. You keep your money in your account and follow our clear instructions for trades, which occur only about three times per year. We provide you with weekly updates of your strategy and an analysis of the market that always tells you what's critically important.
Plus, you can subscribe without risk because each model is backed by a 60-day, 100% Moneyback Guarantee if you decide that algorithmically based strategies are not your cup of tea. Our firm, Optimized Investments, Inc., has an A+ Rating with the Better Business Bureau and a perfect record of satisfied customers – no complaints – since the BBB began reviewing our firm, which was founded in 1998.
Take a moment to sign up for the strategy of your choice now – while all the benefits of a quantitative approach are fresh in your mind. You can get started for less than 50-cents a day with a very low-risk, high-profit investment strategy that produces solid performance through thick and thin – in any type of market environment.
Moreover, remember that you have nothing to lose – if you change your mind anytime in the first two months – for any reason (or no reason at all) – just let us know and we'll return every penny you paid! Visit our ETF Investment Strategy Suite today and select the quantitative strategy that's perfect for you:
Visit our ETF Investment Strategy Suite