Will the Recent Volatility Morph into a Buying Opportunity?

The past few days have been a wild ride for the stock market.

Heading into the week, the volatility resumed Sunday evening as equity futures plunged, pointing to another thrashing on the heels of nasty back-to-back declines. The major US indexes opened Monday morning down another 4-5% in what looked like another ugly day for the stock market.

At that point, the market was as statistically oversold as it was at the deepest point of the October 2008 and March 2020 waterfall declines.

There have only been three times in history where the S&P 500 (its predecessor index in this case) was down 4% or more on three consecutive days. All three occurred during the Great Depression. In addition, the Nasdaq has never had three consecutive declines of more than 4%. Needless to say, odds of another 4% daily decline were low yesterday, even though we started the morning out there.

Eventually, prices fall far enough to attract new buying demand. We may have seen capitulation yesterday morning, but in order for that to have truly occurred, everyone who wished to sell would’ve sold, leaving room for buyers to step in and overwhelm any remaining selling pressure.

Heading into this week, more than 60% of S&P 500 stocks were down 20% or more from their respective peaks. While the S&P 500 has not officially entered a bear market (based on closing prices), when we look beneath the surface, many individual stocks are already in the dreaded territory. The Nasdaq slipped into a bear market this past Friday.

Volatility Spikes Often Create Buying Opportunities

On a brighter note, we examined 15 historical cases (since 1928) in which the S&P 500 (SPY Quick QuoteSPY – Free Report) had consecutive daily losses greater than -4.5%. Over the next month, the index lost ground only twice and only once over the following six months. With the exception of the Great Depression era, these types of swift and large corrections normally occurred near important bottoms in the market.

Last Thursday and Friday, the S&P 500 fell 10.5% which marked the 5^th largest 2-day decline since 1950. In the past, these outsized 2-day declines have typically paved the way for enhanced market gains moving forward.

In bull markets, volatility spikes can coincide with low-risk buying opportunities. Yesterday, the volatility (VIX) index hit the 60-price level intraday; on a closing basis, the index increased 118% from Thursday’s finish, which was the 5^th largest 3-day spike in history.

Image Source: StockCharts

Averaging the 20 biggest 3-day spikes in the VIX, the S&P 500 has advanced 16.5% one year later. It remains to be seen if this time will follow the course of history, but as we can see, the index is falling sharply today as stocks rise. High levels of fear and volatility create opportunity.

With yesterday’s negative market open, well over 80% of S&P 500 stocks traded at a 1-month low in the early hours. Looking at forward returns following a spike in 1-month lows to more than 80%, S&P 500 stocks were higher in 14 out of 16 previous instances looking one year out, with an average gain of 22%.

Image Source: Zacks Investment Research

Final Thoughts

The historical statistics we shared clearly point to an increased probability of a bounce, but whether the bottom is in for this latest correction remains to be seen.

Through it all, the most important thing for us to do is to manage risk effectively. Risk remains high in this environment and volatility is likely to remain elevated. But the price action over the past two days is certainly a step back in the right direction for the bulls.

Still, the market needs time to repair the recent damage. This is a good time to put in the work with watchlists and be ready for new leaders to emerge, so that we can act decisively when the time comes.