Stock Market Investment Risk Remains at Historic Extreme

| March 11, 2013

Our computer models analyze a large basket of fundamental, technical, internal and sentiment data in order to calculate our Secular Trend Score (STS) and our Cyclical Trend Score (CTS). The historical data used by our models extend back to the market crash in 1929 and have enabled our STS to correctly identify every secular inflection point and our CTS to correctly identify more than 90% of all cyclical inflection points during the last 84 years. Additionally, when analyzed together, these data identify extremes in the risk/reward profile of the stock market from an investment perspective. In early February, stock market investment risk increased to the highest one percentile of all historical observations, joining a select group of seven time periods. The additional short-term gains of the past month have increased investment risk even further, creating one of the five worst risk/reward profiles since 1929.

It must be noted that this particular measurement of investment risk is not a top call or an indication that a severe market decline is imminent. Overbought rallies such as this one can remain overbought for a long time as speculative momentum carries prices to higher and higher extremes. What the current investment risk/reward profile tells us is that a severe market decline will almost certainly occur after the current cyclical bull market terminates. At a current duration of 48 months, the bull market is long overdue for termination and it is highly likely that the next cyclical top will form sometime during the next six months. Additionally, the speculative nature of the advance during the last ten months indicates that the final blow-off phase of the rally is likely in progress, so a long-term reversal could occur at any time.

It is important to understand the difference between investing and trading. In order to properly evaluate the investment merit of a particular asset class or vehicle, a minimum time frame of ten years is required. By our measures, which are based on the historically reliable valuation model, the S&P 500 index is currently priced to produce a total annual return of 3.2% during the next decade. This is extremely poor projected performance, especially when you consider that the current yield on the 10-year Treasury note is 2.05%. Of course, given that stocks remain mired in a secular bear market that began in 2000, there will continue to be violent, extreme price swings in both directions. Those moves will continue to provide excellent trading opportunities, but the next true investment opportunity likely remains several years away. Now remains a time for extreme caution from an investment perspective and we remain fully defensive.


Category: Commentary, Market Update

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