U.S. Stock Market Corrections History - How to Avoid Big Drops

Wasssup, hope your trading is going well. As you probably know, all major financial markets are related, to varying degrees. Therefore, in order to understand how FX markets will move, you must also understand what is going on in bonds, indices and other markets.

Today, I'm happy to present some research from Troy Bombardia. He will show you why he thinks the U.S. Stock Market is due for a big correction, based on stock market corrections history. Troy is not the only one who believes this. Also keep an eye on pairs like EURJPY, which can be highly influenced by the S&P500.

So without further delay, here's Troy…

– Hugh

Note: In this post, the words “U.S. stock market” and “S&P 500” are interchangeable. I believe that the S&P 500 best reflects the state of the U.S. stock market. It is much broader than the Dow and is not as tech-focused as the NASDAQ.

The long term, multi-year movements of the U.S. stock market are not random. The S&P moves in clear cycles, which is why many large corrections are actually predictable.

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People say that the crash of October 1987 came out of nowhere.

I disagree.

Here are my 2 favorite signals that can foretell many large corrections.

If the S&P Rises 80% Within 2 Years, Watch Out

Every time the S&P rises more than 80% in less than 2 years (504 trading days), a large correction ensues. Sometimes this signal comes out a little early, but by the end of the correction the S&P will be far lower than where it was when the signal came out.

This is a classic mean reversion signal. Whenever the stock market rises too quickly in too short an amount of time, it is “overbought” and must revert to its mean.

An 80% rise in less than 2 years is very difficult to achieve, which is why this signal has only come out 3 times in the past 50 years.

April 14, 2010 – This was only 8 days before a 17% correction began. This correction lasted 2 months.
March 20, 1998 – This was 4 months before a massive 22% correction began. This correction lasted 2.5 months.
August 7, 1987 – This was just a few days before a 33% correction began that culminated in the crash of October 19, 1987. This correction lasted 2.5 months.

The S&P Must Make a 10%+ Correction or a 4 Month Long Correction Within 3 Years, at Most

Like the previous mean reversion signal, the S&P has a time limit on how long it can rally without a “significant” correction. Some people define “significant correction” is a correction in which the S&P 500 falls more than 10%.

Defining “significant” this ways is nonsensical.

The purpose of a correction within a bull market is to washout some of the overbought momentum. A bull market cannot go up forever and ever without falling from time to time, so corrections are actually healthy for bull markets.

A correction that's “significant” enough to washout momentum does not have to be big percentage-wise. It can be big time-wise. That's why I define a “significant correction” as one that either falls more than 10% or falls for more than 4 months.

The last 10%+ correction ended in June 2012. From a historical standpoint, the S&P cannot go up for more than 3 years (750 trading days) without falling 10% or falling for more than 4 months.

Here's the Data

Rally Start Date	Rally End Date	How Long Rally Lasted
6/4/2012	next 10% correction	744 days (and counting)
10/4/2011	4/2/2012	124 days
7/1/2010	5/2/2011	210 days
3/6/2009	4/26/2010	286 days
8/16/2007	10/11/2007	39 days
8/13/2004	7/16/2007	734 days
3/12/2003	3/5/2004	248 days
10/10/2002	12/2/2002	36 days
2/28/2000	3/24/2000	19 days
10/18/1999	1/3/2000	53 days
10/8/1998	7/19/1999	194 days
4/14/1997	7/20/1998	319 days
7/16/1996	2/19/1997	151 days
4/4/1994	5/23/1996	541 days
4/8/1992	1/31/1994	459 days
10/11/1990	1/15/1992	318 days
1/30/1990	7/16/1990	115 days
10/20/1987	1/3/1990	557 days
9/29/1986	8/25/1987	229 days
7/25/1984	8/27/1986	528 days
8/9/1982	10/10/1983	297 days
3/27/1980	11/26/1980	169 days
10/22/1979	2/13/1980	79 days
3/1/1978	10/5/1979	405 days
9/17/1975	9/22/1976	257 days
12/9/1974	7/15/1975	150 days
10/4/1974	11/6/1974	23 days
11/23/1971	1/11/1973	285 days
7/7/1970	4/28/1971	205 days
5/26/1970	6/9/1970	10 days
2/13/1968	12/2/1968	179 days
10/10/1966	9/25/1967	241 days
6/29/1965	2/10/1966	157 days
6/25/1962	5/13/1965	726 days

The S&P rallied for 3 years without a significant correction in only 2 other historical cases:

From 1962 to 1965 – After this rally the S&P fell 11%
From 2004 to 2007 – After this rally the S&P fell 12%

The current rally has lasted 3 years (as of mid-2015).

Thus, it's reasonable to expect a large or a long correction to begin any time now.

Conclusion

I am developing some other long term technical indicators that can help predict large corrections. All of these are based on some form of mean reversion.

For example, we all know that the stock market can get insanely overvalued, so valuation isn't really that useful. However, what I'm finding is that a lot of times the S&P will make a large correction when it reaches a minimum valuation target.

About the author: Troy Bombardia is an independent medium term trader who blogs over at Trading Slugger.

He uses long term technical indicators and medium term mean reversion indicators to trade stocks and commodities. He specifically focuses on the U.S. stock market and the precious metals markets.