Why do bank stocks fall continuously

Stock markets usually continue to develop after waterfall-like crashes

Stock indices such as the SMI and the Dow Jones have already risen by almost 30 percent after the heavy price losses. But what happens next? The crash is almost always followed by a test of the lows. It should be interesting for investors to take small steps.

The situation on the stock markets has eased, volatility is falling, and after the panic there has been some calming down. Since their lows in mid-March, the leading stock indices in the US and Europe have already recovered considerably by between 25 and 30%. However, the American Dow Jones, the German DAX and the Swiss SMI are still well below the sometimes record high levels seen in mid-February. Does that mean the worst in the stock markets is over?

Comparison with the years 1929 and 1987

Of course, nobody knows the answer to this question, as it depends heavily on the further spread of Sars-CoV-2 and the economic consequences of it. According to Bernhard Langer, head of quantitative investment strategies at US fund provider Invesco, the market is now developing constructively. In his view, the US will set the trend for European equity markets. But especially in the United States, he still worries that New York is in a veritable coronavirus crisis. The US was very unprepared for the spread of the virus, similar to the UK. The recent flattening of the US curve made him cautiously optimistic.

To assess future developments, it is worth taking a look at the past. After a waterfall-like slump in the stock market, as seen from the end of February to mid-March on both sides of the Atlantic, the resulting lows were almost always retested after a brief recovery. According to calculations by Ned Davis Research (NDR), the waterfall lows of the Dow Jones were undercut again in almost 70% of the cases before the stock markets rose again in the medium to long term.

Although there is no general definition of a waterfall-like price fall, according to experts, such a fall is characterized by continuous sales over several weeks, no more than two days with a countermovement in a row, a sharp increase in trading volume and a collapse in investor confidence. The most recent slump, arguably the fastest price fall in history, met all of these criteria. It can only be compared with the waterfall-like crashes of 1987 and 1929.

Small caps mostly lead sustainable recovery

According to NDR, there have been 13 waterfall-like declines in the USA since 1929. In 9 of the 13 cases the Dow Jones broke below the waterfall lows again, and in three of the remaining four cases the Dow retested the lows. The exception was the crash in the fourth quarter of 2018. At that time, the policy of the US Federal Reserve (Fed) was the cause of the sharp decline. But when the Fed changed its policy, prices rose again. On average (median value), one phase of the reverse test lasts two months according to the calculations by NDR.

Observers divide the soil formation process after a waterfall-like crash into four phases. First, the stock market is very heavily oversold, followed by a recovery rally, which in turn is followed by a test of the lows. The experts call the fourth phase a market-breadth boost. During this phase, the vast majority of stocks have to develop a dynamic upward movement in order to signal the start of another bull market. From a statistical point of view, in such an upward movement, stocks with a small market capitalization (small caps) each achieved a higher return than blue chips in the first three months. In terms of industries, financial stocks, standard consumer goods and technology stocks are among the preferred sectors.

According to Langer, market participants are now primarily looking at which companies will survive the crisis. In the initial recovery, he believes that the values ‚Äč‚Äčthat have previously fallen the most will rise the most. This applies, for example, to the shares of oil companies, airlines and banks. In the case of airlines such as Lufthansa, however, it is still an open question whether the state might join the company as a shareholder.

When does the waterfall lows test start?

The recovery rally is currently under way on the equity markets, which, given the already substantial price gains, could perhaps come to an end soon. Then the retest of the previous lows may start. Due to the impressive recovery, the market observers from Wellenreiter-Invest no longer expect the lows to be undercut again (significantly). If the running rally even surpasses the moving average over four years, it would be suitable for a back test, they say.

The difference between phase one and phase three is that the backtest should ideally be done with less total trading volume, less volume in the falling stocks, fewer stocks with new lows, and fewer stocks below their major moving averages.

Entry in several small steps

For the market breadth boost, the fourth phase, investors should pay attention to the corresponding data. Market breadth signals are, for example, when 90% of the stocks are again trading above their moving average over ten days or even better over 50 days. This also includes a rising price day when more than 90% of the trading volume occurs in rising stocks or when the advance / decline line reaches a value greater than 1.9 over 10 days. The Advance / Decline line puts the number of rising and falling stocks in relation to each other.

Langer advises courageous private investors who want to take advantage of the massive setback on the stock markets to get started with diversification. In addition, investors should enter the market in three to five steps, each with smaller positions. This would reduce the risks of entering the stock market.

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