The S&P 500 Is Now At Extremes

Submitted by Lance Roberts of Street Talk Live blog,

Today's chart looks at the market from a technical perspective.  While there are a plethora of Wall Street analysts calling for much higher levels for the S&P 500; most of these calls are based simply on the belief that the current trajectory must continue indefinitely.  While you certainly cannot "fight the Fed" the underlying fundamentals and economics that support the markets long term are not present for the party.  What is very important to understand, and can be clearly seen in the chart below, is that despite repeated calls for "ever rising" stock markets in the past eventually left investors devastated.  Markets do not, and cannot, continue indefinitely in one direction. 

Market prices are subject to gravity (the long term moving average) and the longer the duration of the moving average the greater the "gravitational pull" that exists.  One way to measure extremes of price movement is through the use of standard deviation.   One standard deviation from the mean (average) encompasses 68.2% of potential outcomes within a given distribution of data which, in this case, are market prices.  Two standard deviations encompass 95.8% of all potential outcomes while three standard deviations encompass 99.8% of all potential outcomes.

The chart below shows a MONTHLY chart, which is a very slow moving analysis, of the S&P 500 overlaid with Bollinger Bands which represent 2 and 3 standard deviations of a very long term (34 month) moving average. 


At the peaks of the "Internet Bubble" and the "Credit/Housing Bubble" the market never got significantly above 2-standard deviations.  Today, we are encroaching well into 3-standard deviation territory.  Standard deviation analysis tells us that roughly 99% of the potential movement in prices, from the bottom of the correction in 2011, has been achieved.  Furthermore, the extension of the market above the long term moving average is also at levels that have previously been associated with major market tops.

The top graph is a very long term (150 month) measure of overbought and oversold conditions.  It is also warning that the current market environment is stretched very far and that further gains are likely to be limited without a correction first. 

However, therein lies the potential problem.  Looking back at the markets during a bullish trend the market is usually contained between the long term moving average and 2-standard deviations above the mean.  However, when the extension is above the long term mean subsequent corrections are generally more associated with mean reversions.  A mean reversion is where prices fall an equal distance in the opposite direction or well below the long term moving average. 

The current level of overbought conditions combined with extreme complacency in the market leave unwitting investors in danger of a more severe correction than currently anticipated.  A correction to the long term moving average (currently around 1350) would entail an 18.5% correction.  A correction to 2-standard deviations below the long term moving average (which is most common within a mean reversion process) would slap investors with 33% loss.

If you don't think a 33% loss is possible you should be aware that that is about the average draw down of the markets during a normal recessionary cycle.  Not only is such an event possible - it is probable when, not if, the economy slips into an eventual recession. 

IMPORTANT:  We are currently invested in the market and I am not suggesting that you sell everything and move to cash.  What I am saying is that the market is very extended and the risk of a correction of some magnitude has increased significantly this year.   Therefore, if you are close to retirement, or simply just can't afford the risk of a major market correction, then you may want to start reducing some of your portfolio risk and begin to build in some hedges against an unexpected event.  Whatever eventually trips up the market will be "unexpected."

Currently, it seems that most of the world's concerns have been put behind us due to the massive injections of liquidity being injected by the Federal Reserve, BOJ, ECB and China.  The Eurozone crisis has disappeared, recessions in the Eurozone and weak US economic data are of little concern, declining revenue and earnings are readily dismissed as the primary driving force for investors is Fed interventions.  However, it is within this complacency, that an unexpected turn of events can pull the rug from beneath the markets and send money racing for the sidelines.  Unfortunately, for most individuals, by the time they realize what is happening it will likely be far too late to act.


Some additional color from Lance on the Taper...(via Bloomberg)

"If I was Ben Bernanke, there would be two things I've got to be concerned about," Roberts said in phone interview today "One is creating asset bubbles: If you look at yields on junk bonds, they are at historic lows. The other is the margin on NYSE stocks, which is the amount of leverage investors have taken on. Markets have gone virtually parabolic"


"What the Fed has got to figure out is if it's solely because of what it is doing or because of the economy and underlying fundamentals"


"At the next meeting, I would start to put out language that says, 'At some point in the future we're going to see some tapering,' and see how the market reacts. If the market reaction is fine, I would start doing that behind the scenes and announce it later"


"It's very possible we'll see hints come before the next meeting. It wouldn't surprise me to see more articles and more Fed officials talking about Fed tapering before June so there won't be a shock to markets"


"If you look at financial markets, they are extremely susceptible to a sharp, rapid correction. It would kill everything the Fed has put together. Bernanke will condition markets long before he takes action. We may see tapering occur prior to the Sept. meeting"


"I'm predicting nothing specific in the next few months. But in Sept., around the Fed's Jackson Hole event, we could get specific numbers"


Roberts said he expects Fed to announce in Sept. tapering of QE to ~$65b/mo. from $85b/mo., with $10b taken off MBS and Treasuries each, followed by another similar reduction later.


"Here's the problem. Some of the economic data is not improving. If you taper off now and we don't have economic strength, the economy is likely to start to slip into a recession quickly. There are also questions of whether the Fed has reached the limit of its abilities to purchase bonds, and why the boost to asset prices hasn't translated into the real economy. Clearly, there's a broken transmission system."