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Is the Bearish Engulfing Pattern Actually Bearish?

We saw something this week in the Nasdaq Composite that we’ve never seen before.

In the same trading day, the Nasdaq hit both an all-time high and a 1-month low.

Graph showing Nasdaq hitting both an all-time high and a 1-month low

Such a pattern is referred to in the technical lexicon as a Bearish Engulfing or Outside Reversal day. The definition only requires the current day to exceed the range of the prior day, whereas this week it actually exceeded the range of the prior month.

Historically, just how bearish are such patterns?

As it turns out, they don’t seem to be bearish at all. Since 1978, we have seen 477 Bearish Engulfing days in the Nasdaq Composite. On average, the forward returns (1-week to 12-months) are still positive and not meaningfully different than all other days.

Chart showing Average forward returns and average positive forward returns from 1978 to 2017

Note: Price Returns Only, Does Not Include Dividends

Now, one might argue that what we saw this week is significantly more ominous than your average Bearish Engulfing because of how many days it engulfed. Perhaps, but the problem is there is no precedent to compare to as this was the record. Drawing any conclusion, then, would be pure conjecture.

If we narrow the engulfing range to one week, we find 16 prior examples. The returns in this sample do appear to be weaker (-1.4% over the following month and positive only 31% of the time) on average.

Chart showing 1 week high and 1 week low on the same day from 1978 to 2017

The problem, though, is that the sample size (16) here is very small, occurring on average once every two to three years since 1978. Can we really state with any confidence that the returns following such a unique pattern are due to the pattern itself and not just random chance?

No, especially when they run contrary to the larger sample size with a less stringent definition. Which is why I would conclude that the Bearish Engulfing pattern is a misnomer – not because something bearish can’t happen from here, but because we cannot expect something bearish to happen. Regardless of what the Nasdaq does from here, this pattern will not have predicted it.

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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