October’s mini-crash is setting the stage for a happy ending

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From its September high, the S&P 500 Index fell 9.9% in only 27 trading days. This ranks as the fourth-quickest decline from an all-time high (or 52-week high) since 1980.

Naturally this kind of mini-crash sparks bear market fears. We will discuss the odds of a bear market in a moment, but regardless of bear market or not, statistically, this kind of “quick crash” bodes well for the remainder of 2018.

Quick crashes are rare and fear-inspiring. But is the fear justified?

The charts below show the seven biggest S&P 500 SPX, +0.70%  percentage losses within a 27-day span from a 52-week high (since 1980).

Here are some key takeaways:

1. Not every quick crash ended after 27 days.

2. Every quick crash was followed by new highs.

3. On average, it took 74 trading days to reach new highs.

The common denominator among the samples shown is that the S&P 500 was higher a year later every time.

This makes sense. Why? Sudden and persistent price drops grab investors’ attention and spark fear like no other event. Excessive fear almost always washes out “weak hand” investors, and results in strong rebounds.

The chart below — which includes a number of volatility-based sentiment indicators VIX, -4.47%   — enables us to gauge the level of fear seen near the Oct. 29 low.

Based on investor sentiment and other indicators, I stated in my Oct. 26 MarketWatch column that: “Another leg lower to flush out weak hands is still possible, but the weight of evidence suggests that another drop will be followed by a sizable rally.”

The “flush out” occurred the next day, when the S&P 500 dropped as much as 3.8%, the Dow Jones Industrial Average DJIA, +0.74%  as much as 3.6%, the Nasdaq COMP, +0.77%  as much as 5.1% and the Russell 2000 RUT, +1.18%  as much as 2.3%. The VIX, on the other hand, did not spike to a new high, creating a bullish (for stocks) divergence.

Stocks rarely ever top on peak momentum. The January 2018 high was accompanied by peak momentum, which virtually guaranteed new highs. The September 2018 high was not accompanied by peak momentum. New highs are not impossible, but no longer guaranteed. (A detailed “top or not” discussion can be found here.)

Summary

Sentiment and mini-crash statistics suggest this rally has further upside.

However, unlike earlier this year, new highs are no longer guaranteed. At this point in time, I personally believe that a rally toward the September high will be an opportunity to sell.

A more detailed short-term S&P 500 forecast is available here.

Simon Maierhofer is the founder of iSPYETF and publisher of the Profit Radar Report. He has appeared on CNBC and Fox News, and has been published in The Wall Street Journal, Barron’s, Forbes, Investors Business Daily and USA Today.