This spike raises two questions:
1. How did the S&P500 behave in the past after such a strong breakout on increasing volume?
2. Is this short covering or is it the start of a stronger move?
Question 1:
I performed a test of a "Breakout on Volume" similar to the Breakout of Friday.
We can see below the average return X days after such a breakout. The table includes data from 2010. We can see that even though the expected profit is slightly positive, it is hardly exciting: max expected gain is 0.5%, but still better than a loss.
Question 2:
This is a tough question. "Experience" tells me that this type of bounce is typical of a bear market. Unfortunately, I am neither convinced that we are in a bear market, nor that experience will help much in this situation.
Below is a figure that shows the returns X days after a one day S&P500 "Low-Close" price spike higher than 2%. You can see that experience was right: negative returns prior to March 2009, positive returns after March 2009. This figure shows that we can expect returns of 1.63% for the next 10 days (three times what the Breakout Calculator is predicting.)
The figure below is more interesting: It separates the post-March 2009 returns depending on the period during which the spikes occurred.
I have noted in green the four QE periods and in pink the two periods without QE.
The blue line shows the spikes that occurred after the end of QE3.
We can see that the four green lines are the most positive (Operation Twist was the weakest of the four.)
The two pink lines were weaker and the blue line was the most negative.
This analysis tells us that price spikes were good only during periods of liquidity injection.
The current market conditions are best represented by the blue line.
If we dig deeper into the analysis and only consider price spikes stronger than 2.8%, we notice that no such strong spike has occurred since October 2014. ALL the spikes higher than 2.8% occurred during a QE liquidity period, except for three spikes that occurred in August and September 2011.
We can see in the figure below that these three spikes occurred after QE2, while Operation Twist had not been announced yet. At that time, the market was oversold after having been through an air pocket. This large drop followed by a few strong price spikes is very similar to the situation we are experiencing today.
Conclusions:
The strength of the spike of Friday merely indicates that many funds and traders were already too heavy on the short side. The spike occurred because the market is basically front-running a possible announcement of QE4.
Hope is not a viable strategy. This will be recognized very soon. Markets will most probably come back down early next week. It all depends on the time it will take to run the margin calls on Monday (half an hour?)
