"History doesn't repeat itself, but it does rhyme" - Mark Twain
As an ardent New England Patriots fan, I'm quite fond of 2001. The Patriots won their first ever Super Bowl against the heavily favored St. Louis Rams who set the all-time record for offense that year. The Patriots got to the title game with a terrific defense and beat the odds to win the championship. I'm not so fond of 2007 however, when the Patriots had the highest scoring offense (breaking the Rams scoring record) and then lost to the Giants, who were now the heavy underdogs with a tremendous defense. This year's Super Bowl featured the Denver Broncos as odds on favorites with the greatest offense ever (breaking the Patriots record), vs. the Seattle Seahawks and their #1 ranked defense. Well, you know the rest of the story.
The three games were separated by 13 years and were played in different venues and under different circumstances, but many of the events leading up to the Super Bowl were very similar as was the final outcome.
The quote above by Mark Twain is well known in the investment community. It speaks to the fact that market trends and market events recur with great similarity. Not only do events and trends repeat, but the way investors react to these trends is also repeated consistently over and over. History is one of our best gauges for what is likely to occur in the future.
Knowing that history repeats, or at a minimum rhymes, investors look at current trends and leverage their knowledge and experience to consider the similar examples from history that will help them determine what is likely to happen next. The types of questions regularly being asked are, "when have we seen this in the S&P?" or "when has Gold rebounded like this?" Knowing the outcome alone is a great gauge for every trade and investment decision, but also capturing the RANGE of potential or likely outcomes can be invaluable. The questions then can also become, "what is the worst case scenario for the S&P in the next three months?".
Let's answer both questions for the current trend in Natural Gas (NYSEMKT:NG). Nat Gas is up 73% in the last 3 months, and is up 34% in the last two weeks alone. The bull case for a continued run-up includes forecasts for cold weather to persist, further depleting Nat Gas stockpiles in the short term, and the longer term transition from Coal to Gas. The bears point to the vast reserves of cheap, easily accessible Nat Gas and that prices in the short term are being driven by investor enthusiasm that will change quickly when the weather breaks.
The arguments on both sides sound reasonable but vary dramatically. How do we get an effective, and objective, gauge for the typical outcome as well as the range of potential outcomes?
EidoSearch software identified 21 statistically similar instances of this 6 month pattern in Natural Gas' history, and the average return in the next one month historically is -12.1% (displayed via the red line below). That's the typical outcome, but how about the range of outcomes? The top and bottom orange lines in the chart below represent the standard deviation for the historical instances that are up in the next one month and those that are down in the next one month respectively. You can see there is much greater downside risk, than upside potential.
(Source: EidoSearch data as of 2/23/14)
The chart below displays all of the 21 similar historical instances of this pattern in Natural Gas, and how they performed in the next 1 month. It's another way of seeing not only the most likely outcome (average) but also the range of outcomes. There are 7 historical instances of a drop over 20% in the next one month, and not one over 20% to the positive side.
(Source: EidoSearch data as of 2/23/14)
Defense wins championships, and history, modeled objectively, is a powerful ally to understanding future returns. Watch for a significant drop in Natural Gas prices in the next month.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.