(Bloomberg) The U.S. stock market has more room to fall, if the usual cycle for routs and rebounds are any indication.
Typically, the stock market follows a four-step process to finding a bottom after a steep selloff, according to Ed Clissold, chief U.S. strategist at Ned Davis Research, and Thanh Nguyen, senior quantitative analyst at the firm.
The first step is for major indexes to slide into deeply oversold levels. Then markets proceed to rally and then retest lows to see if the bounce will hold. That is finally followed by clusters of “breadth thrusts,” which occur when an extreme number of stocks advance rather than decline in a short period of time.
By several measures, only the first stage of the cycle has been reached. The 14-day stochastic oscillator for the S&P 500, a popular momentum indicator used to determine whether an index is overbought or oversold, fell to 0.045 on April 26, the lowest reading since Christmas Eve 2018, according to Ned Davis.
On Tuesday, the S&P took another leg lower, dropping another 1.8%.
“The bottom line is that the market has achieved the first step (oversold) and is attempting the second step (rally). Until the market can move to step four (breadth thrusts), we view the process as ongoing,” Clissold and Nguyen said in a note to clients. “Financial markets are forward looking, so price-based, or technical, indicators are likely to be the first to signal the downtrend has turned into an uptrend.”
To be sure, the market skipped the third step and didn’t retest lows following a downturn in 2018 and the pandemic lows in 2020. But analysts have noted that the Federal Reserve was far more accommodative during those two periods than now, with the central bank pumping liquidity into the system.
That appears unlikely at this time as the Fed embarks on its biggest and fastest tightening of monetary policy in years to fight decades-high inflation.
Ultimately, whether the current selloff is nearing its end or has months more to go will “depend on whether the Fed fails to achieve a soft landing and the economy falls into a recession,” Clissold and Nguyen said.
Clusters of breadth thrusts have yet to emerge following a recent bounce in stocks. Technical analysts say these moves tend to happen around the beginning of new uptrends for equities.
Ned Davis strategists are watching for two 10:1 up days, or those when advancing volume is at least 10 times declining volume without an intervening 10:1 down day. May 13 marked a 14:1 up day, but the 17:1 down day last Wednesday after a steep decline restarted the clock for a double 10:1 up day, they said.
“As the 2018 and 2020 declines show, the market can skip step three if there are widespread breadth thrusts,” Clissold and Nguyen said. “Until then, treat the U.S. stock market as one in a downtrend and trying to find a bottom.”