Most investors accept that the market is being driven by the Fed's quantitative easing attempt to inflate asset prices, and thereby jump start the economy. It's also well accepted that when the Fed finally does take the foot off the monetary gas pedal, the market could face some difficulty. What's unclear, however, is whether the run so far this year might not already be too extended and therefor susceptible to an major correction soon.
There are all sorts of conflicting points of view. For example, we recently learned that Goldman Sachs needed to raise its year-end estimate because the original estimate had already been met. Even with the market's run so far, it still forecasts "considerable upside to the S&P 500 during the next few years... We forecast the S&P 500 will rise to 1775 by year-end 2014 [+9% from today] and reach 1900 by the end of 2015 [+17%]." With the market already having advanced more nearly 16% year to date, it's easy to become afflicted by acrophobia and suffer from nose bleeds. But exactly how vulnerable would the market be to a severe reversal if continued to an S&P Index of 1700 (for a 19.2% 12-month gain), 1750 (22.7%), or even 1800 (26.2%) by year-end?
Some look to internal metrics -- like the percentage of stocks making new highs vs. those making new lows, the percentage of stocks exceeding their 200-day moving averages -- to measure the market's health. Others look at more fundamentally based statistics like the market's average price/earnings ratio or the ratio of market value to sales. The calculations and analysis seems so daunting and overwhelming. I prefer the market's own history, however, to tell me whether it has become "overbought" and if its momentum might soon begin to slack. The metric I use to gauge how vulnerable the market is to a reversal as its momentum cools down is the very simple and easily calculated 12-month rate-of-change oscillator. The ROC oscillator is calculated as the percentage change of the S&P 500 from its level 12 months earlier at each month-end.
Since 1940, there have been 876 (73 years x 12 months = 876) of these 12-month periods with the market advancing 69.7% of the time. The average change in the S&P 500 for the 876 12-month periods since 1940 has been 8.09%. The largest advance was an unbelievable 53.4% during the 12 months beginning June 1982 and ending June 1983, when the market recovered from the effects of the 1979-82 recession (see my recent article titled "The Similarity To 1979-82 Is Uncanny") after exiting the 1970s secular bear market. Twelve months after that unprecedented bull run, by June 1984, the market was 8.8% lower. This can best be seen in the following chart:
Click to enlarge images.
Most of the 12-month periods during which the market rose by 30% or more (identified by a dotted red line) were usually followed by fairly dramatic reversals. Conversely, market declines of -15% or more in any 12-month period (identified by a dotted green line) were usually soon followed by equally dramatic reversals and increases. We can extrapolate various tracks for the market to the end of this year, and we can see when the market might be to become overextended and, based on historical experience, vulnerable to a significant correction or reversal.
For the past 12 months, the monthly changes in the S&P Index since May 2012 have been 1.16%. If we extrapolate growth in the S&P 500 Index at the recent average monthly rate of 1.15%, we see that the Index touches 1800 by year-end while the oscillator would be only 25.921, still far from the historically danger zone of 30.00.
The 30% level would be reached only if the market were to reach 1872 by year-end. It would then be overextended by historical standards.
The market will hit 1800 by year-end, and at that level would not trigger an overextended condition by historical standards. The bull market will remain intact and any correction would probably be no greater and of no more consequence than those that happened in 1984, 2011, and 2012.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.