Assessing Market Risk

4/2/2012


The Forecasts does not advocate all-or-nothing market timing. No market tool or indicator is infallible, and investors should not use any single indicator with unwarrranted precision. Instead, we advise using time-tested tools as guidelines to gain perspective on the market's trend and risk level, then drawing on that perspective in concert with other information and analysis to make decisions.

For the market's primary trend — which typically lasts eight months or more — the Forecasts is a big fan of the Dow Theory. For discerning the market's risk level over shorter periods, our Intermediate Potential Risk Indicator is quite useful. The indicator appeals in part because of its simplicity. It uses just one data point — the percentage of stocks on the New York Stock Exchange (NYSE) trading above their 200-day moving average.

The indicator blends two important and related investment concepts — mean reversion and contrarianism. Like weather patterns and human emotions, stock prices can run to extremes in the short run. Over time, however, such bursts of energy dissipate and conditions eventually revert to the "mean," or average, level. For stocks, we start with the 200-day moving average as an equilibrium price. When many stocks trade above (or below) this equilibrium price level, mean reversion is likely to occur at some point, moving the market down (or up).

Notice the use of "at some point." Mean reversion does not necessarily occur immediately. Market history shows us that stock prices can stay at extreme levels for what seems like a long time. We use the Intermediate Potential Risk Indicator to provide perspective on market risk, not to pinpoint the exact time of a market shift. 

Contrarianism is an investment philosophy that hinges on mean reversion. Contrarians believe the market is vulnerable when investors reach the apex of their euphoria for stocks. If everyone loves stocks, there is no one left to buy and drive prices still higher. Conversely, if everyone hates stocks, a lot of buying power is on the sidelines, funds that could potentially enter the market and drive stocks higher.

The Intermediate Potential Risk Indicator serves as a popularity index for stocks. When investors feel euphoric, the percentage of stocks trading above their 200-day moving average will be high. When investors sour on stocks, the indicator's low readings will reflect their worries.

Like most financial signals, the Intermediate Potential Risk Indicator is most effective at extreme readings. When the percentage of stocks trading above their 200-day moving average rises above 70%, the market carries higher risk, while percentages below 40% signify lower risk. To quantify those percentages, the Forecasts looked at market returns going back to the beginning of 1990, as shown below.

RISK VERSUS RETURN
% Of Stocks
Above 200-Day
Moving Average
S&P 500
Index 12-Month
Returns (Average
Since 1990) (%)
Below 20%
25
Below 30%
11
Below 40%
9
Above 70%
8
Above 80%
8
Above 90%
6

After periods when fewer than 20% of stocks on the NYSE traded above their 200-day moving averages, the S&P 500 Index averaged a 12-month gain of 25%. Conversely, when the percentage topped 90%, the average year-ahead price change was just 6%.

At both extremes, stocks still on average managed positive returns over the ensuing 12 months. This should not surprise us, given the stock market's long-term upward trend. Of greater importance than the overall market return, however, is the gap in performance as you move in either direction toward the outliers.

Reflecting the market's strong run over the last five months, 77% of stocks currently trade above their 200-day moving average. That puts us in higher-risk territory, buttressing arguments that the market is due for a pullback. Of course, the Forecasts would view such a pullback as a correction within a bull market, given the Dow Theory's bullish reading of the primary trend. Be aware, however, that the indicator has not reached the extremes (above 80% and especially 90%) that would point toward a more imminent pullback. Thus, while a correction could happen any time, the market could also move higher or sideways before a significant correction unfolds. For more on our market expectations, read the Market Commentary.


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