Relax: Buy The S&P 500

|
Includes: SPY
by: QuandaryFX

Summary

Recent volatility is quite in-line with 85 years of history; in 90% of similar years, price rallied over the next 3 months.

The 200 day moving average has been pierced - contrary to popular belief, this is a good buy signal.

Employment is bettering - this is a strong buy signal.

If one were to read the headlines these days, he or she would have much to fear. Topics ranging from volatility and warfare dominate the news. In the words of CNN: "Investors are scared out of their wits." It is during volatile times like these that I believe investors should step back to examine data and history rather than listen to the 30-second clips that pundits provide. In light of history, I believe that now is an excellent time to purchase the S&P 500 (NYSEARCA:SPY).

Perspective on Volatility

Let's start by examining volatility. Several headlines have screamed that volatility is out of control and fear is running rampant in the markets. While fear is running rampant, I do not believe that volatility is "out of control." Rather than simply stating this, I have gone back and examined 85 years of volatility in the S&P 500 and summarized my findings in the following chart.

The blue line represents the average volatility, in percentage terms, in each month of the year since 1929. The red line is the average volatility of the S&P 500 in 2014. There are some key observations that we can glean from this data. The first is that historically speaking, October and November are the most volatile months of the year. This is important to note in that it means that the heightened volatility we are presently experiencing is nothing out of the norm - this is the typical pattern of the market for this time of the year. The second observation is that volatility for 2014, even in light of recent market movements, is still significantly below historic averages. This means that despite the headlines and fear indices, from a percentage standpoint, things are still pretty normal.

Let's take this analysis a step further. We've seen that volatility is quite normal, but we need a directional recommendation. I have gone back and used correlation analysis to find the most similar years to 2014 since 1929. I then asked the question: in the most similar volatility environments, what happened to the S&P 500 over the next 3 months. Here is the answer:

  1. In 90% of similar years, the S&P 500 increased between now and December by an average of 6%
  2. In 10% of similar years, the S&P 500 decreased between now and December by an average of 9%

In other words, there's a strong likelihood that the market will continue to rise through year-end.

Moving Averages

"But wait," you say, "Bloomberg just told me that the market is below its 200 period moving average. Doesn't that mean that prices will continue to fall?" Let's test that. Here's what they're talking about.

Many fund managers use the 200-period moving average to help gauge market direction - when price falls below the average, it can signal the beginning of a bear market. There are two important things to note about this. The first is that the 200-period moving average has been pierced multiple times over the past decade and only once did it signal a major market decline. The second thing to note is that a fall below the 200-period moving average is very common for this time of year - brief corrections are the nature of the season.

As you can see in the chart above, over the past 85 years, there have been 257 days in which the prices have fallen below the 200-day moving average. The majority of these declines have occurred during October. The fact that price has fallen below the average during the last week is nothing more than the typical nature of the market. In fact, let's disprove the bearish hypothesis proposed by these traders.

Even though price has declined below the moving average, history strongly indicates that the market will continue to rise in the future. The chart below shows a breakdown of historic likelihood of price increase over a certain number of days following a cross below the moving average. The black line shows the 50% threshold - if a data point is above this line, it means that on average price increased historically this many days after the initial cross.

The implications of this chart are profound. This means that over the past 85 years, the S&P 500 has on average increased in most of the weeks, months, and quarters following a decline below the 200-period moving average. In other words, history indicates that you should ignore the technical fear-mongers, fade their recommendation, and buy the S&P 500.

The Economy

What I haven't seen accurately portrayed by the media is the fact that unemployment is decreasing. Instead of focusing on the good, most stations I watch seem to only run fear-inducing pieces. Not only is the employment situation in the United States bettering, but historically, this has been strongly correlated with market gains. In the table below, note this correlation using 3-month changes in unemployment and S&P 500 returns.

A very clear relationship exists between employment and the market. As employment improves, the market improves. As jobs are lost, the market declines. Not only is this simple and logical, but it also proves the opportunity for profit. I have gone back and tested the most correlated periods of time over the past 64 years. What I have found is that in 71% of all similar unemployment environments, the market rallied over the next 3 months. In other words, if the past is to be any guide to the future, there is a significant possibility that the S&P 500 will continue to rally.

In light of historic volatility, market and economic momentum, I recommend that you ignore the hysteria and buy the S&P 500.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.