Stock Market Investment Risk Holds at Historic High

June 6th, 2013
in contributors

by Erik McCurdy, Prometheus Market Insight

Editor's note: The was written 13 May 2013.  That day the Dow closed at 15,091.68, on its way to the recent closing peak of 15,409.39 on 28 May (a gain of 2.1%).  Every day but one from 17 May through 30 May the Dow closed above 15,300.  This was a broad top, not one that needed to be caught within a day or two.  On 05 June the Dow closed just below 15,000 (14,960.59) and on 06 June just above at 15,040.62.  The Dow is virtually where it was three weeks ago.  If you missed this when posted originally on Prometheus Investment Thought 17 May (Global Economic Intersection home page, just below Live Market Commentary and just above Video of the Day in the right hand column), here is another chance to consider this analysis with the market much where it was when written but with three more weeks "on the books".    

Follow up:

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. Since early February, stock market investment risk has remained in the highest 1 percentile of all historical observations, joining a select group of five time periods that include the long-term tops in 1929, 1973, 2000 and 2007.

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As always, 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 50 months, the bull market is long overdue for termination and the next cyclical top could form at any time. Additionally, the rally has taken the form of a prototypical speculative advance as modeled by a log periodic bubble. This mathematical formula replicates market behavior extremely well during unsustainable advances and the following chart from a recent weekly commentary at the Hussman Funds website displays the high degree to which the current stock market rally is exhibiting the classic characteristics of a bubble in its final stage.

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The most recent uptrend from November has moved higher at an unsustainable rate, gaining nearly 22 percent during the past six months and becoming extremely overbought on a short-term basis.

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Any breakdown could signal the development of the latest cyclical top, so it will be important to monitor price behavior closely during the next several weeks. Now remains a time for extreme caution and we remain fully defensive from an investment perspective.

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