Tuesday, November 9, 2010

Post-election Indecision 2010

The party is done and the balloons have been popped (if you are a Republican), but what have the coming two years of gridlock got for the S&P?

In a previous article in October on the state of the S&P I had summarised:

So while bulls may fret, they look to hold the advantage going forward. Time will tell ... but an immediate meltdown would be an event out of the (historical) blue.

On the day of the article (October 11th) the S&P closed at 1,165. At the time of writing the S&P was trading at 1,216, a 4.3% gain. Post-election gains were helped in part by the Fed decision to pump an additional $600 billion into the economy.

So, have we a "sell the news" scenario?

Over the course of these articles I have studied the relative position of the S&P to its key moving averages, chiefly the 20-day, 50-day and 200-day SMAs and compared performance to similar historic matches dating back to 1950.

In the current scenario we have an S&P which is 1.6% above its 20-day MA, 5.1% above its 50-day MA and 6.7% above it 200-day MA. Just to give these values context; on March 9th 2009 the S&P was 16% below its 20-day MA, 25% below its 50-day MA and an incredible 40% below its 200-day MA. By October 15th of the same year the subsequent rally had taken it to 21% above its 200-day MA with modest gains above its 20-day and 50-day MAs.

In relative ranking, Wednesday fell into the 30 percentile (32% to be precise) of ranking bullish days in the market (and climbed again on Thursday's big gain), so it sits more on the frothy side of things, but not necessarily at a reversal point.

What comparable scenarios do we have now to past S&P behaviour?

There were periods of similarity; taking from the day in question and counting forward for up to 1 year returned some interesting findings:

If we look at the next-day trade (1-day) there was an average return of 0.1% with a 95% confidence interval of -0.1% and +0.4%. On Thursday the S&P jumped 1.9% as it followed through on the new stimulus package from the Fed. A jump which was well outside of computed intervals. The closest historic match to this was in 1989 when the S&P jumped 1.8% but ultimately found itself down 8% a month later.

However, the net sum is not bad news for bulls. Historically, markets have tended to outperform going forward. The following chart shows the mean and 95% confidence interval return for the S&P based on the aforementioned tabulated data.

If we base a cyclical bull market start from the March 2009 low then it's not unfeasible - despite the economic doom-and-gloom - for a modest bullish environment to continue for stocks into 2013 or more as is typical for cyclical market longevity.

Pessimists will focus on the 2000 debacle and the sharp losses which followed as the basis for their outlook. From the S&P peak of 1,530 in the latter part of 2000 to the September low of 944 in 2001 the market shed 38.3%. If the exact same scenario was to repeat today then the S&P would bottom around 759 within the next two years, assuming a top at Friday's close. For this to come true there would have to be a decisive break of the (so far well defended) psychological 1,000 level and a loss of the reaction low at 869, which at the time was the 40-week MA as-well as the 'neckline' for the 2009 bottom. So it would not be unexpected for buyers to dig in at one of these two defence points.

Zignals Chart Image

So, while it's easy to diss the advance there is little evidence to suggest it will all come tumbling down like a house of cards.

Prudent profit taking while maintaining a positive outlook is the way to be until the market decides otherwise. It will take a hard break of 1,000 for the S&P to offer up a bearish tone, and even then the risk of a bear trap will be great given the market will have to drop 18% to get there (based on Friday's close).

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