Over the past 6 months, a diverse set of market factors have driven the S&P 500 (SPY). In this article, we're going to examine these historic drivers and make a trade recommendation based upon the current market environment. Specifically, individuals should consider buying the market now due to the fact that the Fiscal Cliff isn't that important.
The chart above shows the past two quarters of trading data for the S&P 500. Over this time period, the market has increased nearly 7%, but volatility is such that these gains have been very erratic. Let's get into the specific market drivers which have historically dictated trend direction. The numbering below corresponds to the labeling on the chart above.
- In June, the market began to be driven almost exclusively on speculation surrounding QE3. Over the past 3 years, the market had been propelled to new heights by the Federal Reserve's asset purchasing programs. The Federal Reserve was attempting to stimulate business by decreasing the yield curve. The economic benefit of these programs was debatable, but the stock market returns were clear: as the Federal Reserve pursues quantitative easing, stock prices rise. Beginning in June of this year, the market became very attentive to any hints of QE3 and it subsequently rallied 11% until the announcement of QE3 on September 13th, 2012.
- On September 13th, the Federal Reserve announced QE3 and I, believing in further momentum, recommended purchasing a leveraged ETF (SPXL) to capitalize on the announcement. I was wrong and I cut out of my trade in two weeks with a 4% loss as it became obvious that QE3 would not continue to propel the market to new heights. The important lesson that incident taught me is that widely-anticipated market events seldom have the impact that is expected. For example, the market rallied 11% into the lead-up to QE3 and ceased to rally within a week of the announcement.
- In the month following the announcement of QE3, it became evident that the market was concerned about the Fiscal Cliff. The economic ramifications of this event are significant and have been discussed elsewhere. Between mid-October and mid-November, the market erased most of its pre-QE3 gains and fell below the technically-critical (200) period simple moving average. The (200) period moving average is the average closing price of each day for the past 200 days. The first chart in this article shows the (200) period moving average for the S&P 500. Many traders monitor this average and price tends to flirt with this figure during potential changes in trend, as can be seen in the chart above.
- On Monday, November 19th, the markets rejoiced when it appeared that a solution had been reached for the Fiscal Cliff. Currently there's a stalemate between the House and the Senate as to how we should resolve this problem and the market hailed what they viewed to be a balm to its qualms. I purchased the SPXL again at this point, but not due to the fact that an "agreement" had been reached.
The market is essentially being driven by fears and hopes surrounding the Fiscal Cliff. I am a contrarian trader by nature; therefore I tend to be very critical of popular sentiment and widely-held beliefs. The public believes that the Fiscal Cliff will have a very significant drag on GDP which will pull the United States into recession and destroy stock market returns. Let's question this thinking. Does a change in GDP actually influence stock direction? Please examine the chart below and then let's talk through the numbers.
The chart shows 32 years of quarterly final-release GDP changes (on a year-over-year basis) and the corresponding S&P 500 value. While examining this chart, ask yourself a critical question: do increases or decreases in GDP affect stock market trend direction? No. Mathematically speaking, there is a .004 correlation between quarterly GDP changes and quarterly S&P 500 changes. This statistically means that the relationship between GDP and the stock market is spurious - there is no relationship between GDP and market returns. In other words, if you're making investment decisions based upon GDP, you're making a poor decision. A prime example of this erroneous thinking occurred between 2006 and Q1 of 2007 in which GDP stalled and began to decline while the market continued to rally 20%. Macro traders who relied on GDP changes for signals were crushed during this time period. Does it make sense that investors are selling stocks in anticipation of GDP declines? No.
The current market price action affords an excellent opportunity for the contrarian trader. By purchasing the market now, investors stand to gain much by risking little. It is during moments of market fear and uncertainty that confident moves can be rewarded by excellent profits. Here's my thinking:
- The market believes that the Fiscal Cliff will drag GDP into oblivion and ruin world markets. History has shown that GDP has a negligible effect on stock prices. Even if we "fall off" the Fiscal Cliff, the market probably will not tank as well, as witnessed by historical correlation between GDP and the S&P 500. More than likely, a last-minute deal will be reached and the markets will rally, say "whew!" and continue rallying for the next few months.
- The public is screaming about fear and uncertainty. I've been watching the markets for a few years now, and I can honestly say that the most widely-anticipated events tend to never occur as expected. This truth was proven to me on September 13th, 2012 when I purchased SPXL when QE3 was announced and lost 4% over 2 weeks.
- The (200) period moving average lies directly beneath the last two weeks' trading action. This level has historically acted as support and I believe it will do so in the future. Rather than spend our time discussing the merits of the (200) period moving average, I've decided to simply provide raw data showing the validity of this trading method. The graph below shows the cumulative historic performance of being long when price is above the (200) period moving average and being short when price is below the (200) period moving average for the past 62 years. Why not skip the fear and uncertainty of the moment and rely on a proven method which has stood the test of time? Statistically, mathematically, logically, and systematically speaking, you should be long the market going into the Fiscal Cliff.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPXL over the next 72 hours.