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What Follows a Roaring Market?

Friday, December 16, 2016

Sheila Jamison and Rich Jamison

Financial markets have enjoyed a significant run-up since the election. Now, we’re hearing two questions daily:

“Should I get out now?”

“Is it too late to get in now?”

We’d love to be able to tell you we knew! You’d likely find that a welcome break from our usual “nobody KNOWS what the market will do” response.1

As always, we attend to what the market is doing. We supplement that with what it has done under similar circumstances, knowing that things are always subject to change and past performance cannot guarantee future results. Still, it’s interesting to see if there has been a pattern.

There is no reason to belabor the point that it is doing well. If it weren’t, we wouldn’t be addressing it. So how has it done under similar conditions previously?

First, we need to quantify “doing well” in order to measure things. We can do so technically by looking at overbought2 status using the S&P 500 index for our illustration of the broad market. As of the market close on December 13, the S&P 500 index itself and many stocks within it have achieved technical overbought status. They were not only overbought, 76% of the stocks were in overbought territory. Moreover, they were significantly overbought with 43% of them more than 50% overbought. The average of all stocks in the index was abutting the 40% overbought level.3

We don’t reach the 40% overbought territory often. It’s only occurred 20 times before this since 2000. That tends to make people view it as an “extreme” condition. We feel we need to evaluate it by looking to what commonly occurred previously from that level.

The question, of course, is what does this mean for actual stock prices and the index? A return to the more usual condition, called normalization, can occur in two ways. One is that the market can consolidate or pull back. The alternative is that the market can continue to generally rally (though at a slightly less frantic pace), with the trailing 10-week band catching up to stock prices. Here’s a look at those 20 times we’ve been here before.

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The points that jump out are

  • 16 of 20 times, the S&P 500 was higher 1 month later
  • 17 of 20 times, the S&P 500 was higher 3 months later
  • 19 of 20 times, the S&P 500 was higher 6 months later, and
  • The average of 20 years was higher for 1, 3 and 6 months

This, of course, runs counter to any interpretation that suggests the market must "crash" because it is overbought. Overbought readings obviously have not meant the end of the world. In fact, historically, it has been quite the opposite.

We contend that reaching this level isn’t a sign of weakness to come. Becoming this overbought most often isn't a bad thing for the market going forward. In fact, historically it has been a positively trending market that is able to achieve such an overbought reading in the first place. Note the absence of the index reaching the 40% overbought level in 2000, 2001, 2002 and 2008.

If you’d like to discuss your specific situation, we’re here and ready to talk with you.

1. Full Disclosure. We’ve heard one correct response to “What will the market do?” That response is widely attributed to J.P Morgan who said, “It will fluctuate.”

2. This is defined as an index or a security trading above the middle of it 10-week trading band – a statistical calculation showing dispersion versus central tendency.

3. There was a bit of a pullback on Wednesday after the Fed interest rate announcement that is reversing up again today (Thursday) as we write.

The data above were taken from sources deemed reliable. However no guarantee can be made as to their completeness and accuracy.
Nothing in the above is meant to be, nor should it be construed as, investment advice or recommendations to buy or sell any security. Individual securities, whenever mentioned, are for illustrative purposes only and may not be relied upon as investment advice.
All indices are unmanaged and are not illustrative of any particular investment. A direct investment cannot be made in any index.
Past performance is no guarantee of future results.

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