When stock markets are oversold, we can expect strong returns over the next few days. But in the long term, returns gravitate toward the average returns. Thus, oversold stock markets only predict short-term results, not long-term. We do a backtest to prove our point.
When there is “blood in the street” the media takes interest in what happens in the stock market (and rarely at other times). You might get scared out of your positions when the headlines on internet sites catch your attention, so it might be interesting to know what happens when stock markets are oversold.
The stock market is very mean revertive and when stock markets are oversold you can expect a short-term rebound up:
What is mean-reversion:
You have probably heard the statistical expression regression to the mean. Regression to the mean means that any strong deviations from the trend are likely abnormalities that later reverse and go the opposite direction.
This is what mean reversion is about: outliers turn around. It’s the opposite of momentum and trend-following.
Of, course, there is no rule without exceptions. There are no certainties in the stock market, but as a general rule, we would say this hypothesis is somewhat true.
What does oversold mean?
Oversold means that the market has dropped much in a defined period of time. For example, if you are looking at a time frame in trading of ten days, you need to define how much it should fall during this period to label it as “oversold”.
Let’s make an example of how you can formulate a hypothesis of what is oversold and which oscillating indicator to use:
What happens when stock markets are oversold?
Why would we say that the stock market is mean revertive? What happens when stock markets are oversold? We can show what happens when stock markets are oversold by running a simple backtest.
We do a simple backtest that has the following rules:
- We buy at the close when the 3-day RSI is below 20.
- We sell at the close when the close is higher than yesterday’s high.
This is all there is to it. We use the Relative Strength Indicator (RSI) because it’s a typical mean revertive indicator that measures the velocity of the up and down days. When RSI shows low values, it signals that the market has dropped significantly over the last three days and is oversold. We then enter at the close and we wait until the market gets a solid up day in the opposite direction and closes above yesterday’s high.
If we backtest this simple trading strategy on S&P 500 from 1985 until today, we get the following equity curve:
The equity curve shows 100 000 invested in 1985 and profits are reinvested up until today. The blue lines are the drawdowns from any peaks in the equity curve.
However, please keep in mind that this strategy didn’t work particularly well before 1990.
Please also read what happens when stock markets are overbought.
What happens when stock markets are oversold? Conclusion
In our opinion, the backtest above shows what happens when stock markets are oversold : the markets usually bounce back (but markets can eventually turn round and continue sliding).