Stock Market Investment Risk Rises to Another Notable Extreme

| July 29, 2013

They are the four most dangerous words in the vocabulary of an investor: “This time is different.” This view was embraced by mainstream thinking during the stock market bubbles of 2007, 2000 and 1929. It has also been embraced today, during the stock market bubble of 2013. These four time periods also have the dubious distinction of carrying the highest investment risk of the past 85 years. Our Secular Trend Score (STS) and Cyclical Trend Score (CTS) are calculated using a large basket of fundamental, technical, internal and sentiment data. 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 percent of all cyclical inflection points during the last 85 years. Additionally, when analyzed collectively, these data identify extremes in the risk/reward profile of the stock market from an investment perspective. Since early February, stock market investment risk has remained in the highest 1 percentile of all historical observations. The latest speculative advance during the last five weeks has increased risk to another historic extreme, joining a select group of four time periods that includes the long-term tops in 1929, 2000 and 2007.

As we often emphasize, 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 on the order of 40 to 50 percent will almost certainly occur after the current cyclical bull market terminates. According to these historical data, the S&P 500 index is priced to produce an annual return of 2.8 percent during the coming decade. Therefore, when you take into account the current yield of about 2 percent, these highly reliable data suggest that stocks are poised to gain nothing during the next ten years. Of course, given that we are in a mature secular downtrend, the market will likely go nowhere in an interesting fashion and it is likely that the extreme cyclical moves that have characterized market behavior during the last 13 years will continue.

The final, speculative phase of the current cyclical bull market that began in early 2009 continues to unfold in typical fashion. The uptrend has essentially “gone parabolic,” accelerating into an unsustainable advance that will almost certainly be followed by a correction of equally violent character.

Given the advanced age of the cyclical bull market from 2009, any breakdown could signal the development of the latest cyclical top, so it will be important to continue monitoring price behavior closely during the next several weeks. Now remains a time for extreme caution and we remain fully defensive from an investment perspective.


Category: Commentary, Market Update

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