Reversion To The Mean In '09?

January 15, 2009

Despite so much gloomy economic news, a review of both the market's technical and fundamental factors paints a much less dour picture.


At first glance, the market's breakdown on Wednesday looked fairly broad.

Some 95% of the companies listed in the S&P 500 finished with lower share prices. And all 30 of the Dow Jones industrial average components wound up down for the day. How bad was it? Since this latest market correction started in October 2007, only four days have had bigger falls on the S&P; five if you count the Dow.

A lot of doom and gloom is being spread by the major media outlets right now. On Wednesday, it was news that U.S. retails sales dropped almost twice as much as most analysts had been expecting.

But from a technical standpoint, all is not lost.

The market is a leading indicator. By contrast, most of the negative economic signals we're getting now are lagging indicators. So while we might see a test of November 2008's lows in stocks, there's reason to be hopeful that certain sectors are actually going to rally going forward.

The SPDR S&P 500 ETF (NYSE: SPY) closed at $84.37 on Wednesday. Its near-term level of price support would appear to be $81.80 per share. Despite more than a half-dozen attempts to breach that price point in the past several months, SPY has held firm.

But as investors, we have to be realists. If the ETF falls below that line of support, it will be revisiting levels we haven't seen since the late 1990s. The problem is charts indicate that the next support levels would come only after another 12% free fall. In terms of the S&P 500 Index, that would mean tumbling to the 660 level, down from its current 843 value.

Using All Tools Of Analysis

From a technical standpoint, it could go either way at this point. But these are times when analysis using charts can be greatly aided by fundamental research. It's important to step back and gain some perspective on the current condition of the market.

Next week, the inauguration takes place of a new president. There's likely to be a honeymoon period for at least 100 days. And a strong argument can be made that most of the bad news concerning retail sales and other broad economic data have already been priced into the market at this point.

It's also important to note that down days in the market lately have shown successively less volume traded each time. That means institutional investors aren't dropping out in droves.

In fact, there really have only been two days since Dec. 1 where we've seen 300-point price swings. Before that, such huge fluctuations were regular occurrences for nearly three months, beginning in September. So volatility does seem to be subsiding.

Reversion To The Mean

Another point to keep in mind is that trailing 10-year return averages for major U.S. stock indexes are at their worst levels since 1827. Generally, that means momentum should be building for markets to experience a strong reversion to the mean.

Just last week, we learned that job losses have been accelerating at the fastest pace since 1945—when Johnny came marching home from war.

However, it's important to note that five months after those terrible job numbers came out following the conclusion of World War II, stocks rallied 17% and produced a nice extended run.

This history of markets snapping back is a significant factor to take into consideration when viewing last year's dismal returns. During 2008, every major sector performed poorly. Normally, we'll see something go up as something else falls. Last year was very much an anomaly, and one can logically expect to see markets revert to more normal give-and-take tendencies going forward.

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