One way to predict how the stock market will fare in one year is to identify where we are in a cycle. We can do that by analyzing historical cycles. The potential benefit is that cycles tend to repeat themselves and therefore if we can pinpoint where we are in a certain cycle than we may have the ability to forecast accurately one year ahead. The danger is trying to compare history to the present where no actual connections exist.
We derive proprietary measures to identify where the US stock market is in its cycle. The measures are calculated using insights from behavioral finance and agent-based modeling. We find our measures have the most predictive power one year ahead.
In the past several months our long-term measure for the US, (long-term meaning predicting one year out), jumped significantly from a low level (bullish) to a high level (bearish).
Our history goes back until 1970. We identified all the examples in the past since 1970 where the US measure jumped from a low to a high level. There were 4 examples in the past 40 years. Those dates include August 1978, April 1986, January 1994, and April 2006. Below is a figure that displays the measures starting at those dates and lasting for around one year. The x-axis is the number of weeks. I also included July 2007 to July 2008 measure because I have read many articles arguing that we are about to repeat 2008 all over again.
Figure 1: BFIA Measures for the US Stock Market
One Year Measures for Time periods in 1978, 1986, 1994, 2006, 2007, and 2011
First of all, every measure except for 2007 starts around the same point. In July 2007 the US measure was already elevated. That is a distinct difference between today and the other historical periods displayed. However, today's measure is following a 2007 pattern. If today's measure moves up, then I could argue we could see another 2008. Therefore, the next one to three weeks are crucial.
The other measures moved up significantly and drifted down for the next year. However, popped back up in the following year. For example, in October of 1979 and March of 1980 the US stock market was hit hard. Of course, October of 1987, more than one year after April of 1986 the US stock market was hit hard. A year after January 1994 the US stock market was fine. A little more than a year after April 2006 the US stock market started to go down before the 2008 crisis hit. Below is a table of the one year price returns with a start date following the dates above.
Table 1: One year S&P 500 Returns
After 1978 the stock market took a hit in 1979 and 1980 but the market bounced back quickly. After 1986 in 1987 the hit was large and bounced back but still took time to get back where the market was before the October crash. After 2006 the US stock market too another large hit.
Here is what we see. If the US stock market's return is low over the next year, we do not predict any major US stock market corrections. Of course the US stock market could go down let say 15% but it will rebound quickly if that happens.
If the US stock market earns over 13% in the next year then we recommend raising cash before another correction comes.
We do not predict another 2008 financial crisis right now, but the next one to three weeks are crucial. If anything occurs to replicate 2008 we will be sure to notify our readers. However, if the market earns too a high return over this next year, another large correction may come based on historical analysis.