In our article "Financial Implosion? We Think Not," on December 1, 2011, we predicted that financial markets would begin to stabilize. So far this prediction has been correct. This prediction was based on the dynamics of our behavioral indicators in the past.
For those that have not read our articles in the past, our behavioral indicators are proprietary measures. A low behavioral indicator indicates low risk, which is bullish and a high indicator indicates high perceived risk, which is bearish. We create indicators for all global markets. The indicator in this article is in reference to the US equity market. If the indicator increases to above its crisis threshold it indicates a crisis is on the horizon.
Our prediction of the stabilization was based on the history of our behavioral indicators. Since 1970 we found four pervious periods, 1971, 1978, 1986, and 2006, in addition to 2011, where our behavioral indicators went from a low number to increasing just below a crisis signal. At the point where the indicator reached crisis territory, financial markets stabilized, meaning price increases and decreases were modest, with a price uptrend.
However, one of the observations we also found was that when our indicators increased from a low value to a high value iover a short period of time, financial markets stabilized over the subsequent year, and then after that the year there was a crisis. If this holds again we then predict a small crisis at then end of 2012. Before we explain this prediction more, let us take a look at graph that shows the evolution of our past behavioral indicator for the US equity market in addition to the current 2011-2012 indicator.
Figure 1: BFIA Indicators for 1971, 1978, 1986, 2006, 2011
In Figure 1, the X axis is the number of weeks. It can be seen in Figure 1 that the all of the measures increased significantly to the point of the crisis threshold. However, the 2006 which increased significantly did not reach the crisis threshold. Afterwards there was a period of stability. The 2011-2012 measure reached the crisis threshold and is now in its downward phase similar to the other periods.
What is remarkable for all periods included above is that from the onset of the significant increase in the indicators it took one year and six months exactly for a crisis to ensue. Since the increase in the indicators began in August of 2011, if this same evolution holds the US stock should experience an up trend for the majority of 2012 and a significant fall in the equity market by the end of the year. So far the evolution of 11-12 indicator is validating this prediction.
Our recommendation is to stay fully invested for the majority of the yea,r as we expect decent positive returns. Therefore, investing in broad US market-based ETFs such as SPY, IWV, and IWW. However, once the fall comes around, we suggest hedging or selling a part of your portfolio in expectation of a significant fall in the US markets.