Playing Whac-A-Mole with a Sharp Mean-Reversion Bounce

This is just an update to the mean-reversion setup currently in play for the S&P 500 (and SPY). I will also post the regular ETF report later today, probably around 10AM ET. The mean-reversion setups were explained in detail last Friday,  Saturday and Sunday. In short, the S&P 500 was extremely oversold after Thursday’s close with a 5-day Rate-of-Change of -11.69% and 14-day RSI at 20.15. The S&P 500 closed off its low on Friday, but down for the day and remained extremely oversold (-12.42% in six days and RSI at 19.16).  

The extreme oversold setup was in play Friday and now we are in the midst of a strong mean-reversion bounce. The S&P 500 is up 6% in 3 days and RSI is at 44.13. The strategy noted over the weekend involved buying oversold and selling when RSI(14) moved above 50. RSI is close to 50 and could make it, but a 6% surge in three days is more than enough for a mean-reversion trade in the S&P 500 or SPY.

The chart below shows the S&P 500 with RSI(14) and the 3-day Absolute change in RSI. Note that this was created in Amibroker with a custom indicator. RSI is coming from very low levels and is up 25 points the last three days (from 19.16 to 44.13). Had RSI started from 25, it would be at 50 now and suggesting an exit. This 3-day 25 point move, nevertheless, is exception because it is the biggest since November 9th, 2016.

There is a big difference between now and November 2016. The November surge in RSI marked an upside momentum thrust after a correction because the Index and Sector Breadth models were bullish in November 2016. As noted last Friday, the breadth models are now bearish and this means we are in a bearish environment. The rules are different.

Click here for an article and video explaining the indicators, signals and methodology used in the Index Breadth Model. This article also includes the signals of the last five years.

The next chart shows SPY with 14-day RSI over the last 18 months. In particular, I would like to call your attention to October 2018, which is when the breadth models turned bearish. The yellow zones mark a 50-61.8% retracement of the initial decline and the 50-60 zone for RSI(14). SPY reversed twice in these zones (early November and early December 2018).

SPY just moved into the 50-61.8% retracement zone with yesterday’s close (and Tuesday’s intraday high). This is a danger zone because the breadth models are bearish. It means we are well in the midst of the oversold bounce and the going could get tough from here. RSI has yet to reach its danger zone, but is up 25 points in three days.

Note that if SPY and the S&P 500 are in danger zones, then the broader market and most ETFs (stocks) are also in danger zones.

In general, I am not a big fan of shorting the market, ETFs or stocks because bear market rallies can rip your face off. As we just saw, SPY is up 6% in three days. Volatility increases in bear market environments and this makes it even more challenging. In general, one needs to sell-short when overbought or near a reversal zone and exit with targets. It requires a close watch.  

Thanks for tuning in and be careful out there.

-Arthur Hill, CMT
Choose a Strategy, Develop a Plan and Follow a Process

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