Last week’s gains in the stock market highlight the increasing bullishness of traders. But one little-known indicator shows this market looks surprisingly like 2007. However, because longer-term indicators show economic strength, any sell-off in stocks should be brief.
Bulls Might Be Pushing SPY Up Too Fast
One indicator I watch closely is the distribution of returns. In the long run, markets tend to be up about half the time and down about half the time. When market gains are recorded much more than 50% of the time, we often see a market reversal.
I also look at the average size of the daily market gain. Small changes are normal. For example, since 2001, SPY has closed up on 54% of all trading days with an average daily gain of 0.02%.
Since the beginning of the year, there have been an unusually large number of up days in SPY and the average daily gain is more than four times larger than the long-term average.
Through the end of August, SPY has gained an average of 0.09% per day and has been up on 58% of trading days since the beginning of January. This is the best performance in the first eight months of the year since 2007 when SPY was also up 58% of the time. The average daily gain in 2007 was only 0.03%.
Over the long run, stock prices show a tendency toward mean reversion. This means that periods of above-average performance are often followed by periods of below-average performance. With stocks delivering above-average gains in the first eight months of the year, it is logical to expect below-average gains in the rest of the year.
However, trends can continue longer than expected, and mean reversion can also be achieved if prices remain in a trading range for an extended period of time.
For now, I believe that a trading range or a short pullback in the stock market will resolve this overbought condition.
Whether stocks move higher or lower from here could depend on the economy. As usual, many analysts had comments on the unemployment report. Unemployment fell to 7.3%, which puts it closer to the Federal Reserve’s target of 6.5%.
Some analysts argued that the report contained more bad news than good. Only 169,000 jobs were created instead of the 180,000 economists expected. The workforce participation rate fell to 63.2%, its lowest level since 1978.
These might be valid concerns, but through testing I have learned that the monthly employment report has almost no relationship to the future trend in stock prices.