Trying to Forecast the Next Fortnight in the Stock Market

Includes: SH, SPY
by: Todd Feldman

We try to identify where we are in the investment cycle. We have written past articles that our model results suggest that 2011 will be similar to 2004. Let us take a look at the return pattern from 11/2003-05/2004 and the return pattern from 11/2010-05/2004.

Figure 1: 2004 vs 2011 Returns

[Click all to enlarge]

The pattern looks remarkably similar. It could just be a coincidence. We could just be extrapolating something that does not really exist.

Let us take a look at what happened on the international front in 2004.

  • About one third of Iran’s Parliament steps down to protest hard-line Guardian Council’s banning of more than 2,000 reformists from running in parliamentary elections (Feb. 1).
  • A. Q. Khan, founder of Pakistan's nuclear program, admits he sold nuclear-weapons designs to other countries, including North Korea, Iran, and Libya (Feb. 4).
  • Spain is rocked by terrorist attacks, killing more than 200. Al Qaeda takes responsibility (March 11).
  • U.S. troops launch offensive in Falluja in response to killing and mutilation on March 31 of four U.S. civilian contractors (April 5–May 1).
What happened on the domestic front:
  • U.S. three-month Treasury bill rate was 1.01%.
  • The value of the dollar was falling.
  • According to the Congressional Budget Office, the federal budget deficit reached a record $413 billion in 2004.
  • In September, Congress renewed its faith in tax cuts by approving the extension of several cuts due to expire by 2006.
There are similarities on the international front. But there is always news coming out of the Middle East, so it's hard to find a similarity there. On the domestic front, interests rate were low but not anything compared to today. Inflation was low as well and gas prices were still low. Inflation is currently low when examining the CPI numbers, but the price of gasoline is rising high. It's hard to conclude on the domestic front things are similar.
If one is to conclude that the similarity in the above return pattern means something, then the U.S. stock market should decline over the next two weeks. In that case, one could hedge part of one's portfolio. An investor can short SPY, buy an inverse ETF such as SH, buy put options on the S&P 500, or short S&P futures.
If one is not fully confident that these similarities will continue, then one can partially hedge the portfolio about 10%. If the stock market rises, then increase the hedge little by little as we approach the seasonal down summer.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.