Photo by Alandmanson - Own work, CC BY-SA 3.0,
https://commons.wikimedia.org/w/index.php?curid=32339503
Andrew Thrasher won the 2023 Dow Award for his paper, “The 5% Canary”. In it, using data from back in 1900 onwards, he notices that the initial velocity of a market’s weakness often determines its further outcome.
All things being equal, if the S&P500 or the Dow Jones Industrial Average lose at least 5% within 15 trading days after the respective index hit a 52-week high, this is quite a negative sign — a canary in the stock market coal mine.
However, this is only the first step. You get a “Confirmed 5% Canary” when the market closes under its 200-day simple moving average for two consecutive days — if this happens within two months, i.e. 42 trading days.
A Confirmed Canary is strong indication that something nasty is going to hit the proverbial fan. I’d be taking a lot of money off the table in such a case.
Contrary Case: When to “buy the dip”?
On the other hand, a market that is softening or correcting in its own sweet leisurely time can be good news for investors. It may mean: this is just a normal downswing; back up the truck, buy some stocks!
Whenever a 5% loss takes longer than 15 trading days to happen, and the market is within a good trend (meaning: in Golden Cross territory), then chances are that this is a buying opportunity.
(Golden Cross = when the 50-day simple moving average is above the 200-day simple moving average. The opposite is known as the “Death Cross”).
So again, we are not only looking for a phenomenon, but also for its confirmation.
Need some historical data? OK — first, on Confirmed 5% Cararies:
Since 1980, there have been just 15 Confirmed 5% Canary signals in the S&P 500 and 14 Confirmed 5% Canary signals in the Dow Jones Industrial Average (…). Included in this sampling are the significant market events that were noted by the 5% Canary signals (…). This includes the Great Depression, 1987 Crash, bear market following the Tech Bubble of 2000, Financial Crisis of 2008, Covid Crash of 2020, and the bear market that began in 2022.
Of the 15 Confirmed 5% Canary signals on the S&P 500 sampling (…), only four did not occur ahead of what resulted in a double-digit drawdown for the index.
Since 1980, only one drawdown of -20% or more for the S&P 500 did not receive a Confirmed 5% Canary signal (the bear market of 1981-1982).
For the S&P 500, the median decline 3- and 6-months after Confirmed 5% Canary signals is over twice the size of the Every 5% Decline group.
And as to Buying the Dip:
Since 1980, the S&P 500 was higher 66.7% of the time two weeks after Buy The Dip signals with a median gain of 2.14%, compared to all declines of 5% within an uptrend, which resulted in a median gain of less than 1%. (…) Two months after Buy The Dip signals saw the market higher 87.5% of the time with a gain of over 5.5%, compared to less than 70% for the full sample of 5% declines that saw a median gain of 3% during the same period.
So, I Am Curious (Canary Yellow): where do we stand as of today?
Yesterday, Monday August 21, was day 15 since the July 31st closing high. Day 14’s drawdown was 4.8%. A close below SPX 4359 on Monday would have indicated a 5% Canary. We closed yesterday at SPX 4399.
So, we’re looking good.
Please keep in mind however that there is nothing magical about the 5% threshold! Neither are those 15 days set in stone. All these rules are just indications of probabilities, as is everything in finance. Whatever has worked in the past 120 years doesn’t have to work in the present or in the future!
Hat tip to Mark Ungewitter, via Twitter @mark_ungewitter, for bringing the Thrasher paper to our attention!
Addendum: in the mean time, SPX has closed at 4335, fulfilling the minus 5% level. But that happened after the 15-day threshold. Meaning, we're in buy the dip - territory.