Stock Market Risk Surges to Another Historic Extreme

November 25th, 2013
in contributors

by Erik McCurdy, Prometheus Market Insight

In early November, our cycle analysis predicted the formation of the latest short-term low in the stock market. Since the last short-term cycle low (STCL) occurred on November 7, the S&P 500 index has moved sharply higher, confirming that a new short-term cycle is in progress. An extended alpha phase rally that moves well above the last beta high (BH) near 1,772 would reconfirm the current bullish translation and favor additional strength heading into the end of the year.

Follow up:

Although the short-term outlook remains bullish, the long-term view continues to urge extreme caution. At a current duration of 56 months, the cyclical bull market from 2009 is long overdue for termination and the character of market behavior during the last 9 months suggests that we are in the final, speculative blow-off phase of the rally.

Additionally, since early February, stock market investment risk has remained in the highest one percentile of all historical observations. The latest speculative advance from October 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.

According to the valuation components of the data used to calculate investment risk, the S&P 500 index is priced to produce an annual return of only 2.3 percent during the coming decade. Therefore, when you take into account the current dividend yield on the index, these highly reliable data suggest that stocks are poised to gain nothing during the next ten years. Granted, the market will likely go nowhere in an interesting fashion, but buy-and-hold investors who are entering the stock market at this level will almost certainly experience extremely poor performance during the next decade. Fueled by a historic amount of stimulus from the Federal Reserve, the cyclical bull market in stocks that began in 2009 continues to exhibit the characteristics of a classic bubble as defined by a log periodic advance. The following graph from the Hussman Funds website suggests that the highly speculative uptrend is in its terminal phase, so the bubble could pop at any time during the next few months.

As with all bubbles, it is impossible to predict when the top will form with a meaningful degree of statistical confidence. However, as with all bubbles, it is a virtual certainty that the next cyclical downtrend will be extremely violent and severe. If this bubble is followed by a typical post-bubble correction, the S&P 500 index will lose 30 to 50 percent during the forthcoming bear market. There will come a time when the risk/reward profile of stocks is once again favorable and the judicious study of market data will signal when that next long opportunity develops, just as it did in March 2009. However, now is a time for extreme caution and we remain fully defensive from an investment perspective.

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