The 1930s guide to whether the rally can continue

The big upward move in S&P 500 contains information of confidence just as big moves contain information about panic and despair. But is a big move an indication of further gains? To get enough samples to conclude anything we analyzed all future paths in S&P 500 over three months following a 10% gain or more in three trading days. There has been 36 cases of the S&P 500 Index moving this much since early 1928. We find 32 of these observations in the period 1929 to 1939 and the remaining four observations during 2008-2009.

The numbers suggest mean reversion on average, that’s lower equities, in the first two trading days following such a big move up in equities. Six weeks out we observe more path leading to gains and on average 6% gains over six weeks. Over a three month horizon there are as many profitable as unprofitable paths but the distribution of cumulative returns are skewed towards positive returns. The biggest 63-day trading day return is 74.4% and the biggest negative return is -36.8%. So history is telling investors that such as big move is succeeded by an extreme range in outcomes. This means that investors that put on long positions here will have to actively manage the position unless they are willing to accept a potential 36% drawdown from yesterday’s close.