Approaching a Rest Stop – It’s Been a Great Year
We are coming into the final stretch of 2013, and what a year it has been, in many cases far exceeding performance expectations on stocks while not meeting expectations on fixed income. The balance of the year will provide folly for the markets with regard to the fundamentals, political posturing, global positioning and investor behavior. Today the S&P 500 stock index reached yet another all-time high, consistent with our earlier observations and expectations on the tailwinds present to the equity market. It is also the fifth consecutive day of the market closing higher than the preceding day. The combination of the two make it a good time to go back to a favorite technical indicator that provides some insight into what the probability is of the market going higher from this level in the short run – we’ll call that the next several weeks. Directionally the multi-year bull market remains intact; however, in the short run, we may have reached an area in market valuation that sets the market up for some sideways trading.
One of our favorite technical indicators for evaluating price trends and potential is a regression analysis. This analysis simply illustrates what the probability of the market moving in any direction from current levels may be. Stick with us here as we know when a person starts to talk about regression analysis eyes start to go tilt and attention spans rapidly drop to zero. Once you understand what the data is telling you, the subject matter can get very interesting, especially when it comes to your money.
As a quick refresher, let’s set the table so that we have a common understanding of the big nuggets with regard to regression data and probabilities. The key terms are mean and standard deviation. Think of the mean as the average, or middle of the range. When the market is trading near the mean, it simply would indicate that there is an even probability of the market going higher or lower, a 50/50 chance of moving in either direction. Once the market extends to one standard deviation above the mean, the probability of the market going higher, in the short run, drops to roughly 16%. When the market gets to two standard deviations above the mean, the probability of the market going higher, in the short term, drops to 2.5%. We are now approaching the second standard deviation for the market (S&P 500 stock index) on both the five year and three year charts, meaning the odds of going higher from here, in the short run, is only 2.5%. Stated another way, there is a 97.5% probability the market will not be going higher, in the short run. In the charts below, the mean is represented by the red line, one standard deviation is represented by the grey lines and two standard deviations are represented by the green lines. With that in mind, for investors that are considering adding new dollars to the stock market, it may behoove them to be patient at this point and look for a better entry point.
5 Year Chart of the S&P 500
Notice how the market is very near the green line, the second standard deviation from the mean, highlighting the fact that the odds of going higher from here are becoming very small in the short run.
3 Year Chart of the S&P 500
The three year chart is also approaching the second standard deviation, yet not quite as close as the five year. Close enough to a two standard deviation event to get our attention.
1 Year Chart of the S&P 500
The shorter, one year chart would indicate a neutral position and not signaling the extended conditions shown in the three and five year charts.
We’ve had a great run, far exceeding full year expectations. Directionally, the bull market in stocks remains intact; however, in the short run, we now may enter a consolidation period that provides for a modestly choppy sideways trading pattern. A pullback of 3%-5% from current levels would not be unexpected as attention shifts to the holiday season as a barometer of consumer confidence coupled with the continued concern over the financial shenanigans occurring in our nation’s capital.
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