The Realities of Whipsaw Risk
Many technical investment strategies, particularly those that are momentum or trend based, rely on security or index price data to guide buy and sell decisions. In a relatively efficient market such as large-cap U.S. stocks, impactful information is quickly incorporated into stock prices, allowing price data to be a fairly reliable indicator of trends in market sentiment. Under certain market conditions, though, price action can become irrational, manifested by dramatic positive and negative moves.
A special case of this sort of price action is known as a “whipsaw”: a large downward/upward move quickly followed by a rebound or recovery. A recent example was the reaction of the S&P 500® Index in late June to the U.K.’s unexpected “Brexit” decision to leave the European Union. The market’s downward move in response to the Brexit vote — a drop of 5.3% over two days — was a “three standard deviation” event to the downside. Statistically, a three standard deviation (or “three sigma”) downside event has about a 0.2% chance of occurring. The subsequent recovery — +6.5% over 8 days — was a two standard deviation event to the upside. An investor away on vacation that week wouldn’t have noticed that anything unusual had happened. The rest of us, however, lived through a stock market that seemed convinced Brexit would be a significant drag on global economic growth. Within days, that opinion had changed 180 degrees, to the view that Brexit was a non-event.
Fortunately, most trend-following investment strategies have built-in mechanisms to mitigate the impact of such extreme, rapidly-evolving events. Even so, we can point to two recent whipsaws that likely impacted many technical traders, illustrated in the chart below.
These events are of particular interest for a couple of reasons. First, the magnitude of the declines was remarkable. The whipsaw that kicked off in August 2015 began with an 11% downward move over six days — a nearly four standard deviation event. The second whipsaw, which began in late December 2015, consisted of an initial 10.5% drop that quickly expanded to 12%.
The other interesting thing about these two whipsaws is their proximity. The historical track record shows that whipsaws are rare, and that multiple whipsaws close together are extremely rare.
From 1927 through 2016, the S&P 500 Index experienced 42 whipsaw events similar to the two seen in 2015 and early 2016. If we filter out those that occurred during the 1920s and 1930s (one could reasonably argue that the market infrastructure has evolved since then), we see 19 whipsaw events since 1940.
Looking deeper into the data, we can identify periods where multiple whipsaw events have occurred within a short period of time. (For our purposes, we looked specifically for multiple whipsaw initiations within a 100-day window).
As expected, we can see that it is rare for multiple whipsaw events to occur in a short time period. Since 1927, the S&P 500 experienced 19 periods with multiple whipsaws. If we limit the time period from 1940 to the present, we see only four periods with multiple whipsaws. A quick review shows that all these time periods represent market bottoms. The odd thing about the whipsaw clustering we just experienced is that they occurred during a strong, long-running bull market.
We occasionally hear about the challenges of “trend-following in a trendless market.” The chart above shows what a trendless market can look like. We should take comfort from the fact that multiple whipsaw events appear to be extremely rare in the historical record, and that the U.S. equity market (as with most securities markets) has not tended to exhibit trendless behavior for long periods of time.
Past performance is not a guarantee of future results.
Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.