Should we prepare for a violent SPX breakout?
After a red-hot start to July, the S&P 500 Index (SPX) has been trading in an extremely tight range lately. Over the last three weeks, the difference between the high and low closing price is just over 1% of the index level. I have read some articles saying we should get ready for a violent breakout, and heard pundits say "never short a boring market" -- meaning it’s a bullish sign for stocks. This week, I used a quantified method for finding past S&P "coil patterns" to see how they have tended to play out.
Entering Coil Patterns: I defined a "coil pattern" as: when the difference of the high and low closing prices of the S&P 500 over the previous three weeks is less than 1.5% of the index price. First, I went back to the beginning of the current bull market (since 2009) and found all the signals and how the S&P 500 performed after entering these coil patterns. There have been 12 other occurrences before the recent one, with the first one happening in August 2012. The short-term returns after these occurrences are pretty bad. So much for "never short a boring market." In fact, the last time we saw this signal was Aug. 17, 2015, immediately before the index fell about 10% over the next week.
Since only going back to 2012 gives us a small sample size, I decided to look back farther and see if the market's recent behavior is normal. Therefore, I went back to the earliest data we have, since 1928.
You can see in the first table we now have 129 occurrences to compare to typical S&P 500 returns. Again, in the very short term you get a pretty poor performance, with the index averaging a one-week loss of 0.13% and positive less than half the time. The typical one-week return is a 0.14% gain, and positive 56% of the time. However, in this table, the volatility going forward is substantially lower across all time frames, as measured by the standard deviation, even in the one-week returns. It seems to me that once the S&P 500 enters these coiling patterns, you should expect a pretty quiet market going forward -- not necessarily a violent breakout in either direction.
Leaving a Coil Pattern: I wanted to look at this one more way. The signal above was generated when the index first registered a three-week high-low difference of 1.5% or less. These coil patterns can last for some time, so I wanted to find out how the S&P 500 performs once it breaks out of this coil pattern. Maybe if I did it this way I would see the violent breakout that has been talked about, or some confirmation that you should never short a boring market.
Going back to 1928, the table below shows returns when the S&P first moves beyond this definition of a coil pattern. You can see the day that it breaks out of the pattern, the index averages a slight loss, with a percentage of positive gains that almost exactly matches a typical market. One thing I noticed is the upside volatility on the day of a breakout is less than usual (indicated by average positive), and the downside move is more than usual. So it seems if you do get a big single-day move from this pattern, it generally goes to the downside.
However, the overall volatility is still smaller than usual that day and across all the time frames going forward. You get some slight stock underperformance in the very short term (day of or one week out), but after that the market gets back to normal. The average return is slightly less than usual out to a month, but the percentage positive is a little bit better. The three-month returns after these patterns shows some slight outperformance. Therefore, I would conclude a slow, boring three-week coil pattern leads to more slow and boring action.
Finally, here is the data on the S&P 500 breaking out of these patterns only since 2012. Looking only over these 12 happenings, we see a little more volatility on the day of the breakout than normal. The average return is negative on the day of the breakout. Really interesting, though, is the one-week returns after it moves out of these coil patterns. The last 11 times it broke from these coil patterns, the index was down over the next week. Only one of the returns, the first one in August 2012, was positive.
However, the market tended to quickly recover from that first week. When you get out to two weeks, the percent positive is back to normal. Looking only at these 12 data points, it seems the index tends to see a quick pullback after leaving this pattern, and then quickly bounces back after that.
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