This is the "Part 4" of a "4 Part" blog series - The Second Quarter Forecast.
As a technical and quantitative analyst I have always wanted to apply historical precedence to draw probabilities that create a statistical advantage. The obstacle is that there are less predictable animal spirits that must be accounted for when considering investor psychology. Forecasting today’s market must account for not only the technical levels but observe when market conditions change and subsequently cause the animal spirits in the investor psyche to shift. So is the ground beneath the bulls feet shifting?
In spite of a rapid correction over the last week, technically the market remains in a distinct multi-year uptrend. The sequence of higher highs and higher lows remains uninterrupted on the S&P500 which recently made all time new highs. The only questionable issue is the recent behaviour of the Nasdaq100 index, and the turn in leadership stocks. Is this a warning that this bull advance has run its course? The Nasdaq has put in its highs over a month ago and continues to exhibit the characteristics of broader distribution. Will the beloved tech and social media stocks, that lead the bull market over the last year, ruin the party? They certainly could.
Our quantitative perspective focuses on applying probabilities based on past historical precedence of similar market conditions. March 2009 marked a significant turn in the markets and the end of one of the greatest bear market declines in our life time. Since that low, the market has advanced over 5 years to the current highs. So how does that compare? Let's compare our current bull market with 3 other notable bull markets from over our generation. All data is based on the S&P500.
So what can we observe? Though not the greatest percentage gain, we have seen the largest S&P500 point rise ever, currently marked at 1231.00 points. As well, we are now 1860 days into the advance. Coincidentally, the three bull markets observed all lasted about 5 years in duration or in the 1800-1900 days. There is nothing stopping the current bull market advance from becoming the longest bull market in history, but at minimum we must recognize that this 5 year bull market is very mature both in duration and magnitude.
So what is the probability that we will see a meaningful market correction in the 2nd quarter? Pretty high. The bigger and more unclear question is -what is the probability that a correction turns into a much deeper crash? That is where the animal spirits come into consideration.
On a comparative basis, where and how low can a market correction go? Throughout history, it is very common for markets to revert back to their 52 week mean price. On average, this has a tendency to occur at least once a year. 2013 represented one for the few exceptions where the market advanced uninterrupted. Observe the chart below.
If the current market simply corrected back to its 52 week mean price, we would see a correction down towards the 1700 level on the S&P500. From the intraday highs, this would be a 180-200 point correction. Corrections/crashes can get emotional, so in market drops like in 2010 and 2011, we saw the market trade 50-150 points below its 52 week mean levels during the most intense stages of the drop. To simply use that past precedence, if we witnessed a comparable correction, capitulation selling could see the 1600 level on the S&P500. That 1600-1700 level on the S&P500 equates to the advertised 10-15% market decline.
The bigger question is not if a market correction will occur, but rather will it be a correction within a bull market or will it mark the beginning of a new bear market. I will stand behind my 2014 Market Forecast from the start of the year that this year is likely to represent a substantial topping formation in the markets, but is not likely to see a start to a bear market until 2015 or further.
While we reserve the right to adapt our forecast if market conditions considerably change, we will be trading the 2nd quarter anticipating a meaningful correction that will still represent a potentially lucrative “buy on dip” opportunity. So increase, or add hedges to your stock positions, raise some cash and wait for a good decline before adding new positions.
The Canadian S&P/TSX60 has substantially outperformed the American market throughout the start of the year. This has been primarily driven by an impressive advance in the Canadian energy stocks and the material decline in the Canadian Dollar. So does the TSX have the same risk of a correction as the American markets? Yes. There is always a certain degree of correlation so it would be a very poor bet anticipating the Canadian market to hold its levels while there is prevailing trend lower south of the boarder. Anticipating the Canadian TSX60 to drop 60+ points from current levels to the 750 level would be a very natural and much needed correction.
In spite of disappointing growth in the economy, the European stock markets have been doing relatively well. European markets have demonstrated correlations to the American markets, so it would not be out of line for there to be material volatility across the Atlantic.
When looking at the emerging markets, there are a number of independent trends. The India Bombay markets have been doing relatively well, while Russia, China and Brazil remain in a choppy muddle. While uncertainty in the equity markets may spill over around the world, many emerging markets have not participated in the rally and have some compelling valuations on a relative basis. While anything can happen, I suspect that many of these markets will simply be more volatile, without much of the downside risk as the over inflated markets in the developed world.
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This is the "Part 4" of a "4 Part" blog series - The Second Quarter Forecast