Follow-Through Day Study Update

Looking to History for Clues of a New Rally

The current uncertainty in the U.S. and global economy has led to a decline in the stock market, with key indices such as the S&P 500, Nasdaq Composite, and Russell 2000 experiencing notable downturns. As of March 6, the S&P 500 is down 2.3%, the Nasdaq Composite has dropped 6.4%, and the Russell 2000 has fallen 7.3%. The S&P 500 is nearing its 200-Day Moving Average (200-DMA), a critical technical level that, if breached, could signal further declines. This precarious position prompts us to revisit historical market corrections to glean insights into potential future trends. By examining past recoveries and downturns, we can better understand the signals that might indicate whether the current correction will lead to a new rally or a prolonged bear market.

Understanding Market Corrections with the O’Neil Methodology

The O’Neil Methodology offers a framework for assessing market trends, particularly focusing on the transition from downturns to upturns. Central to this approach is the concept of a Follow-Through Day (FTD), which is identified by a gain of 1.7% or more on higher volume than the previous trading session, occurring after a three-day period without new lows. FTDs are critical as they often signal the start of a potential rally. The methodology categorizes market corrections into three primary scenarios: Bull Case 1, Bull Case 2, and the Bear Case. Each scenario provides distinct outcomes based on the success or failure of these FTDs.

Bull Case 1: Recoveries Led by Successful First FTDs

In Bull Case 1, the first FTD successfully propels the market toward new highs without significant setbacks. Historical data shows that 19 out of 35 corrections since 1970 followed this pattern, where the market bounced back after the first FTD and continued to set new highs. This scenario is characterized by the absence of new lows post-FTD and steady progress within 4–8 weeks. Notable examples include the recoveries in November 2023 and 2004, where the first FTD was a strong indicator of a sustained bull market. The clarity of this scenario offers optimism for investors if the current market follows suit.

Bull Case 2: Corrections with a Second FTD

Bull Case 2 presents a more complex recovery path, where the initial FTD fails, but a subsequent FTD succeeds. This scenario underscores the market’s resilience, as it overcomes initial setbacks to eventually achieve new highs. Historical examples such as 2018 and 2010 illustrate this pattern, where a V-shaped recovery emerged after the second FTD. The key factor here is the market’s ability to rebound convincingly after the second attempt, signaling a return to bullish momentum.

The Bear Case: When Corrections Lead to Bear Markets

In contrast to the Bull Cases, the Bear Case is marked by the failure of multiple FTDs, leading to a prolonged bear market. Eight out of the 35 historical corrections since 1970 resulted in bear markets, often characterized by multiple failed rally attempts. The median number of failed FTDs in these cases was four, stretching over a year and a half. The most recent example is 2022, where repeated failures of FTDs were followed by a significant market decline. This scenario serves as a cautionary tale for investors, emphasizing the importance of monitoring market behavior post-FTD.

Conclusion: Navigating the Current Market Landscape

As the S&P 500 approaches its 200-DMA, the market’s next moves are critical. Investors are advised to remain cautious, awaiting clear signals from the O’Neil Methodology before making significant portfolio adjustments. The potential for an FTD in the coming weeks could provide crucial insights into the market’s direction. While historical precedents offer valuable guidance, they are not guarantees. Thus, staying informed and maintaining a disciplined investment strategy is essential in navigating the current volatile market conditions.