There is a natural tendency to become more and more suspect of a bull market as its price levels and duration increase. We’re now in the early stages of the 6th year of this bull market, a market which is already the fourth longest in nearly 100 years. Many tops have been called along the way but we have continued higher, either to the dismay of those watching or the delight of those participating.
I’m reminded of a lesson learned back in grade school that applies, but only in the lightest sense. In learning the basics about probability, we, like most others, studied the dynamics of a coin toss and the associated results. Most people will agree that the initial coin flip odds are 50/50. But a funny thing happened as people watched multiple flips of the coin … they started basing their prediction for the next coin flip on the results of prior coin flips.
Specifically, if some saw the penny land tails-up three times in a row, they became more inclined to pick heads for the next toss. After seeing seven tosses land tails-up in a row, they became even more certain that the next toss would be heads. And if they saw the penny land tails-up 10 times in a row, anyone picking tails for the next flip was likely to have their lunch money stolen.
In the coin toss exercise most of us are quick to recognize that the prior history of coin flips has zero impact on the probability of the next coin flip. Each coin flip, assuming a balanced coin, has a 50/50 chance of landing heads or tails. We know this inherently, but we are subjective creatures and it can be difficult for us to look at things from a completely logical perspective.
I admit that it is quite inappropriate for me to use a coin flip analogy when discussing the ongoing duration of a bull market for many reasons. While not the case with flipping coins, there are many factors within markets that can cause a “reversion to the mean” phenomenon: risk/reward trade-offs change at every level, and market psychology plays a dominant role in market direction. I mention the penny analog only to highlight how sometimes faulty rationales can play a role in our ability to see objectively.
Quick side note — I haven’t tried this yet but Science News reported that spinning a penny does not provide the 50/50 dynamic that one may naturally expect to see. According to their research, a spinning penny will land tails-up approximately 80% of the time. This is the result of an uneven weight distribution, with Lincoln’s head being a bit heavier than the opposing side. If anyone’s inclined to try this, let me know the results, as an advantage that large could provide some entertainment value winning drinks or money from unsuspecting bar buddies.
Back to the markets, one other piece of information you may find interesting is that a random day in the stock market has a higher probability of being an up day than a down day. From 1950 – 2013, the market experienced 53.7% up days and 46.3% down days. Since 2010, 55.8% of trading days are up days while 44.2% are down days. This passes the common sense test, as bull markets are generally longer than bear markets, but climb slower than bear markets fall. Markets are also naturally biased to the upside.
A monthly chart of the S&P 500 is shown below, and you can see that the recent uptrend line has not yet been breached. We know that sooner or later the market will roll over and break the trend but we do not know when. Looking at the recent gains as a way of justifying a now-bearish case may not be the best approach to take. For all we know the market could head much higher. That’s why it’s important we not get ahead of ourselves with talk of what may or may not be “inevitable” based on past history. We stay with the trend until the trend changes.
We’ve now reached the point where three quarters of S&P 500 companies have reported Q1 earnings. So far revenue is up 2.6% from last year, a good sign. Earnings had been expected to decline 1.2% and yet are on pace to rise 1.5%. I would have thought that the better than expected earnings would have driven this market higher, but there are a number of issues holding it back. The first is that companies are showing good performance, but forward guidance has not been great. When companies report, more weight is often placed on expectations for future performance than on the recently reported figures.
China is on nearly everyone’s mind and we continue to receive dismaying indications. The final April reading on China’s manufacturing sector showed further contraction. What were initially hoped to be anomalous data points are now pointing to a change in trend. Ukraine also remains an ongoing focus and that may be why we’re seeing demand for Treasuries push yields lower. With headline risk escalating, perhaps it makes sense that we’ve seen the market sit tight.