Something happened in the stock market last week that hasn’t occurred in nearly two months – it went down. Granted, one does have to look fairly closely at the chart of the S&P 500 to see that the result on the week was actually negative. Oh, and in the case of the Dow Jones Industrial Average, there actually wasn’t a decline at all as the venerable index simply pushed on to an eighth straight weekly gain.
However, outside of the DJIA, which seemed to benefit from the hedgies rotating out of the high fliers such as Rovi Corp (ROVI), Apple (AAPL), Netgear (NTGR), Cummins (CMI), Alpha Natural (ANR), and Freeport-McMoRan (FCX) and into the old standby’s such as Home Depot (HD) and Wal-Mart (WMT), the rest of the market got smacked around pretty good.
For Those Of You Keeping Score At Home
For those of you keeping score at home, while the Dow was busy making new highs for the current bull market cycle, the NASDAQ Composite was being crunched to the tune of -2.76% from its high on Tuesday while the Midcaps fell -2.7% and the market-leading Russell 2000 Smallcap index was body slammed by -4.3% over the course of just three days.
Given the ‘joyride to the upside’ that the market has enjoyed since the beginning of September, it isn’t exactly surprising to see the action become a little sloppy lately. After all, everybody who has ever clicked the buy button knows that trees don’t grow to the sky and that pullbacks are part of the game.
But in light of the fact that the market has become splintered lately and the action in the leaders has gotten downright ugly in many cases, we thought it might be a good time to take a look at the risk/reward environment to see what kind of downside potential the bears might have at the present time.
What’s The Reward Potential?
The idea here is to identify the environment and then look back at history to see how the market has done in that particular situation. The problem with this approach is, of course, that you have to first correctly identify the environment.
For this task we turn to the computers at Ned Davis Research. NDR tells us that based on the historical tendencies of bull market cycles; we are likely looking at the last stage of the bull’s current run for the roses. In fact, the cycles suggest that the bulls have another nine months or so of upside before the bears resume possession for a while.
So, what does the final leg of a cyclical bull market look like? The good news is that this is generally a time when things get “fun” to the upside. And then, perhaps more importantly, this is also the phase of the bull market where the downside risk during corrections has been relatively shallow.
To illustrate the point here, let’s go to the numbers. Looking at data from 1929, NDR identified 27 cases of the final nine months of a bull market’s run. During these periods (often referred to as the “final leg” or the “blow-off” stage of a bull market), the average gain for the rallies that led to the peak of the bull market was nearly +28% on the S&P 500. Thus, the “reward” part of our equation is +28%.
It is also worth noting that 96% of the rallies during this type of market phase exceeded +10%, 81% produced gains in excess of +15%, and 56% saw gains over +20%.
What’s The Risk?
On the “risk” side, we see that the average correction that occurred during this phase was -13.2%. But in looking at the data more closely, we noticed that this average was skewed rather dramatically by the ferocious corrections that took place in the 1930’s. If one removes the big declines seen in 1929, 1932, and 1933 from the mix, the average correction is a much more pedestrian -9.65%.
So, with the average “reward” having been +28% for the final phases of bull markets and the average “risk” being -9.65%, the reward/risk ratio comes out to a very favorable 2.9.
In looking further at the numbers, we find that the chances of what we will call a serious correction (defined as a decline in the S&P 500 exceeding -10%) are relatively small during this phase of a bull market. Since 1929, there have been just 11 cases (out of 27) where the corrective phases exceeded -10%.
In more modern times, the odds of a meaningful correction are actually much lower during the last phases of bull markets. In fact, since 1959, only 3 of the 16 pullbacks that have occurred in this type of environment were greater than -10% (with two of those being -10.21% and -12.08%). Thus, if we use history as our guide, we can say that the odds of a severe correction is very low (3 out of 16, or only 18.75%).
But, But, But…
Before you run out and fire up that margin account to buy some triple-long ETFs, we would like to emphasize that this type of analysis should NOT be used as the primary basis for investment decision making. Our view is this data should be considered as, at best, “background” input. And while it may be considered if you are on the fence about the degree of exposure, we always, always, always prefer to stick to our strategies and systems Remember, while history may rhyme from time to time, it rarely repeats the same song.
What’s the takeaway then, you ask? First, the data we explored assumes that the current bull market is entering its final leg and that this leg will last about nine months. As such, if the market continues to act favorably, we’ll say that the dip-buying is still an okay strategy – for a while. The second key here is that corrections during this type of environment have historically been on the shallow side. And finally, it is very important to recognize that unless the joyride to the upside continues unabated due to fundamental factors (such as the economy improving more than is currently expected); an actively managed approach to the market remains THE BEST WAY to play the game for the foreseeable future.
S&P 500 - Last 5 Years
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