The third quarter is now in the past, so I’ll share a few observations of what is going on.
First, below is the S&P 500 stock index over the past quarter. For observation purposes, if we simply define an uptrend as higher highs and higher lows and a downtrend is lower lows and lower highs, what do we have here?
I guess we have to add a non-trend, which is when the price trend made a lower high like it did last month but still bound within the range of the prior low.
No trend analysis is complete without also observing the drawdowns along the way. At this point, the SPX is about -3% off its high and its already getting attention in the headlines.
Stretching the price trend out farther to the past year, we see it is barely positive and I define this trend as non-trending and volatile.
The drawdowns over the past year have ranged from -5%, which we normally see about three times a year, to -20% which is less common.
What about mean reversion?
In investment management, mean reversion is the belief that a stock’s price trend will tend to move toward its average price over time.
So, you can probably see how we can use simple moving averages to illustrate mean reversion and the potential for countertrends.
I don’t trade off of moving average signals since I have my own algorithms that define the trend direction, momentum, and volatility. But, most investors have a basic understanding of moving averages so they are useful for sharing observations.
During the quarter, the S&P 500 dropped below its 50 day moving average, which is a shorter-term trend measure. Yesterday, it trended down below that trend line again. A -5% decline would be normal, as we observe them two or three times a year.
I included the 200-day moving average in the chart as well. The 200 day has been a popular trend following indicator, though it has had many whipsaw signals. A whipsaw is when the price trend trades above or below the moving average and then reverses the other way. Any trend following signal has the potential to result in whipsaws, though some are better than others.
So, what we have here is a sideways quarter with a price trend that has been range-bound. Year to date, however, the stock market is off to a strong start, but that’s because 2018 ended with a sharp waterfall decline that recovered some of the losses the first two quarters this year.
Fortunately for us, we had exposure to alternative assets, some hedging, and some stronger momentum positions that have resulted in a more smooth quarter than is trending in the right direction.
Investors need to realize this is a very aged old bull market and the economic expansion is one of the longest in American history. If you are investing based on recent past returns of the past five or ten years, I believe you are going to experience some longer-term mean reversion in the coming years. By my measures, investors seem to be complacent again, as they were in 1999 and 2007, so it seems we may be getting closer and closer to a different kind of trend.
Investors didn’t want tactical risk management before the big bear markets, they wanted it after the fact.
The next time will be no different.
Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.
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