How The Random Walk Become A Not So Random Climb, And How To Know When The Climb Is Ending

Submitted by Jerry Bogart

A Less-Random Walk Climb and How Will We Know When The Game Changes?

Regular readers of ZH are all too familiar with the market-distorting impact of the various incarnations of QE on the equity markets.  One interesting way of looking at the result is a histogram of daily returns on the S&P 500.  First, the histogram for 1990 through March of 2009:

Now, the histogram for April 2009 thru 2010:

The most relevant observation is the lack of symmetry in the daily returns since April 2009.  In the prior decades, the bars immediately to the right and left of the mode (and on out the distribution) are nearly identical in size giving a VERY symmetrical distribution.  Since April 2009, each pair of bars as you work away from the mode show a clear skew toward the more positive return than the less positive counterpart.

Another observation is that the bin at each “tail” is fatter for the historical returns than for the last 21 months. 

Thus, the stock market has become a less-random climb from its previous random walk.

The ability of QE to achieve these results in spite of Dubai, Greece, Ireland, commodity price spikes and a reversal in 10 year Treasury rates has been remarkable.  That which cannot continue, will . . . until it does not.  How will we know we are approaching the point at which this phenomenon stops continuing?

1.    One could argue that the commodity price and 10 year Treasury increases over the last 60 days are signs that the distortion in equity returns will soon stop and we will see the return of more negative return beginning in January, especially if these trends continue.
2.    As noted in this post, Observations, the turning point may be when the market needs confirmation of the never-ending nature of QE .
3.    There may be an unexpected shock (Icelandic volcano, bankruptcy by major US municipality, terrorist attack, etc) which overcomes the market’s conditioning to “buy the dips” and reliance on the Bernanke put.
4.    Or, the march toward hyperinflation may simply continue unabated with a perpetual positive skew to equity returns that fail to keep up with the rate of currency destruction.