Can the bull market continue? It sure looks like it
by Raul Elizalde - 2013-02-13
As they continue to climb, US stocks are now at the top of the list when it comes to asset class performance. Since the end of 2010 they did better than non-US stocks, bonds, diversified commodities and gold.
The road has not been easy. Investors were asked to keep the faith through a teetering banking system, fears of a eurozone breakup and a Chinese economy hard landing, a downgrade of the United States, unprecedented riots in the Middle East, and a US Legislature practically at war with the country’s President. Such has been the landscape through which stocks traveled to register one of the fastest increases in history. Understandably, many investors did not go along for that ride.
As we noted many times (see, for example, Signs of a market climate change, 1.15.2013) this bull market took place along relentlessly declining trading volume and a steady rotation out of stocks into bonds and cash, both a consequence of investor mistrust.
Equity market strength was interpreted by many analysts as mere proof that central bank liquidity injections can artificially pump up prices, but such intervention was never trusted to last or succeed. Few foresaw that it was a means of buying time while more fundamental conditions were brought back to health – a view that is gaining reluctant acceptance.
In recognition of that, billions of dollars have been moved from bond funds into equity funds in recent weeks. While the amount is nothing but a trickle compared to the ocean that sloshed in the opposite direction for years, it nevertheless suggests that sentiment is changing.
Many investors, however, worry that they may have missed the rally, and fret that buying stocks now might prove to be too late or at too high of an entry point. It is not a secret that a number of market participants hope for a market dip so they can enter at levels they missed. Upcoming battles in Congress about spending cuts and tax increases are the best chance they see for market volatility they can use.
They might be disappointed. Without truly unexpected disruptions, there are virtually no signs that the market rally is running out of steam.
Investors who are waiting for a dip to buy may want to take a closer look at the nature of such dips. One characteristic of bull markets is that prices don’t really fall substantially when they are on. In general, it is better to just buy when the trend is strong than to wait for better entry points.
From late 1990 through late 1997, for example, the S&P500 rose more than 200% without registering any 5-day decline larger than 5.5%. It accomplished the same feat from 2003 through 2007, almost doubling in value during the period.
20-day (4-week) losses larger than 9% followed a similar pattern (see graph above). When such occasional plunges happened they were more useful as warnings than as better entry points. The first dips signaled that the market was approaching a top; more frequent plunges were a clearer indication that a bear market was about to start or was in full swing (grayed areas). Thus dips were signs of danger rather than buying opportunities.
Where are we right now? The depth and frequency of market dips has decreased substantially, and we've had the longest interval without a 5-day decline larger than 5.5% or a 20-day decline larger than 9% since the financial crisis. If history is any guide, this bodes well for a continuation of the rally.
Another measure of market momentum is the relationship between short- and long-term moving averages, which tends to be indicative of conditions on longer time horizons. Currently, moving averages are neatly arranged so that short-term ones stack above long-term ones, a typical condition of bull markets. There is no indication that this state of affairs is losing any momentum at all (see graph).
Finally, correlation and volatility measures continue to decline. As we noted in a recent newsletter (Signs of a market climate change, 1.15.2013) both statistics are a deterrent to buyers when elevated - but for the last few months they have been steadily decreasing. This has given long-term investors comfort that the exasperating “risk-on, risk-off” environment characterized by swings of indiscriminate buying and selling no longer dominates the field.
We are keenly aware that the future cannot be predicted. The crude measures we present here are not to be thought of as “proof” that we are in the middle of a rock-solid boom. In fact, we still harbor many doubts that a new multi-year rally like the massive 1942-1966 or 1981-2000 bull markets is in the cards. Unknown factors can ruin the best outlook, and after years of uncertainty, it is hard to believe that there are no hidden threats somewhere. But judging by market dynamics and an improving fundamental picture, signs that the market rally may be coming to an end are truly hard to spot.
We use quantitative measures to build and maintain dynamical multi-asset portfolios for our clients, using a process that aims at identifying tactical opportunities such as the one described above - all along keeping an eye on controlling potential losses. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment processes works. We’ll be happy to set up a confidential meeting to discuss new paths to financial success. Read more