Stock market likely to retest lows in 4-step recovery process, history suggests

 A turnaround Tuesday followed by a wobbly Wednesday on Wall Street leaves stock-market investors wondering how to proceed after the S&P 500 suffered its largest one-day drop in nearly two years to kick off the week.

The bad news is that history suggests a retest of those Monday lows is likely in order; the good news is that the market is likely to regain its mojo in the coming weeks, as long as a recession remains at bay and the latest episode proves to be nothing more than a growth scare, argued Ed Clissold, chief U.S. strategist, and Thanh Nguyen, senior quantitative analyst, at Ned Davis Research in a Wednesday note.

“The bottom line is that the markets could feel the effects of Monday’s shock for several weeks. However, fundamentals do not align with a major bear market at this time,” they wrote.

They’re referring to the volatility shock that saw the Cboe Volatility Index 

VIX

2.05%

, often referred to as Wall Street’s “fear gauge,” more than double over three days, rising from 16.4 on Thursday to 38.6 on Monday. A move on that scale has happened only four times on record.

The strategists laid out what happened to the market in those previous instances in the chart below:

Illustration: Ned Davis Research

It shows that the S&P 500 

SPX

-0.77%

 has tumbled during the VIX spikes, then rebounded and retested the lows over the following weeks. The sample size is small, but on each of those four occasions, the S&P 500 broke the low seen from the original VIX spike. Three out of four times, however, the index was up a year later by a median of 11.2%, NDR found.

Monday’s close marked an 8.5% pullback from the S&P 500’s record finish scored in July, the largest retreat since October but still shy of the 10% threshold that marks a market correction. Moreover, the market tends to average one 10% correction a year, the strategists reminded.

Read: These sectors thrive in ‘deep recession’ scenario where yields fall and spreads widen, says Citigroup

Clissold and Nguyen noted that the stock market typically sees a four-step healing process after sharp declines. Those steps are “oversold, rally, retest, and breadth thrusts.”

The S&P 500’s 3% drop on Monday clearly left the market oversold, they said, with declining stocks outnumbering advancers by 18 to 1. The 20-day TRIN indicator, which measures advancing versus declining stocks relative to volume, posted its highest reading since the May 2010 “flash crash.”