Will the Market Keep Rising or Drop Like a Rock After October's Big Gains?
So far my conservative stance couldn't have been more wrong for the month of October. While the market is still about 6% off it's highs for the year, it has risen over 13% so far this month. With such a large gain in a month it made me wonder how October, 2011 stacked up to other "mega-months"? I wondered too, "What happens historically after large, double digit gain months?"
To answer that question I had to pull some historical data on the S&P 500 and do a little number crunching. Here's what I found:
Since 1950 (earliest data available on the S&P 500) there have been 11 months where returns were 10% or higher
If the market finishes October where it is today or higher, it would be the second best month ever in the history of the stock market
Predicting 10% of greater months is completely impossible - all historical data is random (data to follow)
For full disclosure, here's each of the "mega-months" and some of the history on what preceded them and followed:
As you can see from the table there is very little consistency as to what happens before a 10% or larger monthly gain in the market. It ranges from nearly 40% declines over the prior year to 22% gains the prior year. In fact, the most random occurrence in this table is the 12 months performance of the market before a 10% or greater monthly gain (using standard deviation to calculate).
For those not familiar, Standard Deviation is a mathematical calculation that measures the variability of data. The larger the number the more random the measurement. The smaller the number the more consistent the measurement.
In the case of this study one thing I found really surprised me.
I expected that after a huge monthly rally in the stock market the market would fall afterwords. In other words, I *though* that it would be unreasonable to expect the market to rise much right after it just went up a bunch.
As you can see from the table...I was wrong.
In fact, the most consistent thing in the table is the average gain the next three months after a 10% gain was already realized in just one month. 9 times out of 11 the S&P continued to climb after these mega-months. The same was true about the 6 months following a mega-month (9 of 10 times the market rose). The average gain the next 6 months after a huge month like this October is a whopping 12.14%!
There's a couple things I take from this simple study:
Huge months like this are very rare, and as such offer very little in sample size - so we have to take this data with a grain of salt
We should not expect that just because the market went up a bunch it can't continue to do so
If we missed part of the rally we don't have to panic, historically there's been plenty more left shortly after
We shouldn't feel silly if we missed the rally - the events leading up to it are totally random
At the end of the day I don't think any of this information is worthy of trading around. There's simply too few scenarios to analyze. In order to effectively test any market influencing factors I much prefer to have at least a few hundred occurrences for testing. It does though make me scratch my head a bit.
More Testing Relative to Current Market Conditions
I also spent a little time looking at the price patterns we're experiencing right now to see if statistical modeling has been wise as of late. In lay terms, our models were not optimistic at all going into October so why exactly was that?
This is best explained with some charts. Specifically the last 6 months and the most recent 6 month stretch that was similar. The way most of the models I build work is that they are designed to learn from recent history in attempt to ensure we A) don't make the same mistakes twice; and B) we position ourselves to profit from uncannily similar situations.
With this in mind, below you'll see the most recent six months of the S&P 500 as well as the six month period of November 1, 2007 to April 30, 2008:
Market 11/1/2007 to 4/30/2008 In both cases the market dropped rather quickly, then rallied back to recover a sizable portion of the losses (though there wasn't a single large month like we've had this October, just a few good months in a row).
In both cases the 50 day average value (blue line) crossed below the 200 day average (red line). This is commonly known as the "Death Cross" and has accurately predicted virtually every major market crash the last 100 years.
Also in both cases the 50 day average is starting to turn up indicating it may have been a false warning and the momentum of the market could start rising.
What the charts (and history for that matter) don't tell us; is what's going to happen next? They only can tell us what happened all the other times this pattern has existed, and most specifically in recent history.
Mathematically speaking (I know, a foreign language for many of my readers) there were enough commonalities and significant long-term data to suggest that even though there is a nice rally happening right now - there's also a major possibility of a sharp decline.
For those that don't remember, the 12 months following April 30, 2008 the S&P 500 lost 38.03% of it's value.
What do I draw from all of this?
Well, as painful as it is to participate nominally in the recent market gains, it's far less painful than losing 38% of my portfolio (and the portfolios I manage for clients). I also know that if this trend continues there will be plenty of upside left, since a single great month historically doesn't mean there couldn't be some nice gains on the horizon. And lastly, I know that using math based models to help in managing investments will identify this current trend as either being totally phony or the real deal relatively soon as the similarities to the 2007-2008 scenario will either have to end in the coming weeks or repeat themselves.
Thanks for the patience while taking a look at this rather long, and rather geeky post.