The Greatest Paradox in Markets

By Charlie Bilello

16 Jun 2022


Stocks go up and stocks go down. Most of the time there’s nothing interesting or exceptional to say about it.

But from time to time, notable extremes occur, both on the downside and the upside. The driving force? The most powerful human emotions: fear and greed.

In the past few years we’ve seen both sides…

1) Fear: March 12, 2020

On March 12, 2020, just 1% of stocks in the S&P 500 closed above their 50-day moving average, one of the most oversold readings in history.

The S&P 500 was in the midst of a crash, down 27% from its February high, and nearly all of the stocks in the index were moving lower.

What happens when stocks are extremely oversold?

They tend to bounce back, with above-average forward returns…

2) Greed: May 28, 2020

And bounce they did.

Just two and half months later, an astounding 96% of stocks in the S&P 500 would close above their 50-day moving average, which at the time was the highest reading ever recorded. The S&P 500 had rallied 40% from its lows in March, and by all accounts was extremely overbought.

What happens when stocks are extremely overbought?

They tend to continue to move higher, with above-average forward returns…

And move higher they did, with the S&P 500 rising another 60% to its peak in early January of this year.

3) Fear: June 16, 2022

Since then, we’ve seen a 24% decline in the S&P 500 (one of the worst starts to a year in history) and today only 2% of stocks in the index remain above their 50-day moving average. That’s the fewest we’ve seen since March 2020.

What happens when stocks are extremely oversold?

Well, you already know the answer. They tend to bounce, with above-average forward returns…

Are these results intuitive?

Not at all. The greatest paradox in markets is that both extreme oversold and extreme overbought conditions tend to be followed by above-average returns.

How is that possible?

It’s likely because extreme strength begets strength (momentum) while extreme weakness does the same (mean reversion). Momentum and Mean Reversion are the most powerful forces in markets, and they exist due to the most powerful human emotions: greed and fear. These emotions cause investors to overreact and underreact to information, again and again.

What will happen from here? There are many possibilities as every bear market is different. The best we can say is what’s more or less likely to happen, and those odds are forever changing.

When the market has been this extremely oversold in the past, it has tended to bounce with above-average short-term performance. But alas, tends to is far from always.

There have been exceptions where the bounce is so short-lived that it is barely noticeable on a chart, and is soon followed by lower lows and yet another extremely oversold condition. We learned this lesson most notably in October 2008.

These “exceptions” to the rule should come as no surprise, for there is no holy grail indicator that can predict the future with perfect foresight. There are only probabilities in the market, never certainties. That’s what makes it so hard to navigate and at the same time so interesting.

Appendix

% of Stocks in S&P 500 Above 50-day Moving Average: 30 Lowest Readings

% of Stocks in S&P 500 Above 50-day Moving Average: 30 Highest Readings


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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.

About the author

Charlie Bilello

Charlie is the founder and CEO of Compound Capital Advisors.

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