Trader's Diary

January 25, 2013 6:28 pm

History suggests this rally has further to run

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Risk-on trade is set to continue unless politics intervenes

The UK stock market has gained 12 per cent and counting since the current rally began on November 19. Some investors now worry that shares have risen too far, too soon and are ripe for a correction.

Are their concerns realistic? While no one can predict the future with certainty, history provides an interesting, and positive, perspective.

During the 2003-07 bull market, there were eight short-term sell-offs when prices fell by at least 5 per cent, about two per year. They began, on average, around five months after the previous sell-off ended (see chart). A similar pattern occurred when our current bull market first began. There were two short-term sell-offs in excess of 5 per cent in 2009. Both began after powerful rallies had run for about three months.

These benchmarks suggest that the current rally has the potential to run for several more weeks or even months before running out of steam.

But the trend suddenly changed in 2010 and 2011 around the time that political weakness and unwillingness to address serious structural problems began to dominate the business news. Investors were riveted by a steady flow of scary headlines about the deteriorating state of the EU financial community, especially in fringe countries like Greece, Ireland and Portugal. Fears emerged that the euro would collapse and throw the entire EU project into turmoil.

The unwillingness of US politicians to resolve pressing debt and spending problems attracted increased media attention as well. Investors were even treated to the unwelcome spectacle of a US government debt downgrade in mid-2011.

The emergence of these leadership issues was associated with a sudden increase in the frequency of sizeable UK stock market sell-offs. There were 12 sell-offs of at least 5 per cent in 2010 and 2011, triple the rate that occurred in other recent bull market years. The length of the average rally that preceded each sell-off also slipped to just 28 trading days, quite a reduction from the former trend.

Happily, the trend returned to past form in 2012. The UK stock market suffered just two temporary sell-offs in excess of 5 per cent last year. Rallies preceding each sell-off typically ran for about four months, quite an improvement from the 2010 and 2011 trend.

David Schwartz
All bets are off if our economic guardians lose their zeal

- David Schwartz

No-one can conclusively prove why the trend suddenly improved. Political bickering and incompetence on both sides of the Atlantic were little changed from the previous two years. In fact, most investors would agree that the level of nastiness in Washington escalated to unimaginable levels. But some important economic events occurred as well. Mario Draghi’s promise to “do whatever it takes” reassured European investors. The Federal Reserve’s continued support of the US economy via “quantitative easing” was another positive step. In addition, there were fresh signs of US economic improvement, including rising employment and house prices.

So what lies ahead? The most recent large sell-off ended about two months ago. Assuming regulators continue to exert a positive influence and politicians do not make things worse than they did in 2010 and 2011, past experience suggests that the current rally could continue for a few more weeks before the next significant sell-off.

For the moment, the signs are looking good. European investors appear to be reasonably satisfied with EU political leadership. Most Americans now blame congressional Republicans for preventing progress on the US financial crisis. I suspect that the survival instinct which is embedded in the DNA of every politician will result in a greater willingness by Republicans to compromise and get on with the business of governing.

But all bets are off if our economic guardians lose their zeal or politicians on either side of the Atlantic go back to the bad old days of 2010-2011.

Stock market historian David Schwartz is an active short-term trader writing about his own trades.

tradersdiary@ft.com

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