Following a moderate decline from its recent highs, the market experienced a “reflex” advance last week. As I noted in the February 3 comment, “Even the shallow 3% retreat from the market’s all-time highs may be enough to prompt a reflexive ‘buy-the-dip’ response in the context of extreme bullish sentiment here, as the S&P 500 bounced off of a widely monitored and steeply ascending trendline last week that connects several short-term market lows over the past year. Regardless, the potential for short-term gains is overwhelmed by the risk of deep cyclical and secular losses. We presently estimate prospective 10-year S&P 500 nominal total returns averaging just 2.7% annually, with negative expected total returns on every horizon shorter than 7 years.”
Needless to say, our concerns are little changed by the last week’s advance, and with this low-volume reflex rally in place, we may observe a much deeper and uncorrected loss if the prior resolutions of severely overvalued, overbought, overbullish, rising-yield conditions are an indication. The expectation of impending market losses should certainly be tempered by the fact that similarly extreme conditions in February and May 2013 were largely uneventful, and were followed by further gains. Still, it’s important to recognize that extreme syndromes of overvalued, overbought, overbullish, rising-yield conditions have previously created risk and instability over a period longer than a few weeks or even months.
Likewise, in the context of log-periodic bubbles – as we’ve observed in U.S. equities since 2010 (see The Diva is Already Singing) – the “critical point” or “finite time singularity” is not a crash date, but the inflection point from self-reinforcing speculation to fragile instability. Didier Sornette observed this more than a decade ago in Why Stock Markets Crash. Our best estimate of that inflection point remains about January 13. It’s also worth remembering that the “catalysts” associated with sharp market losses have often been fully recognized only after the fact, if at all. As Sornette emphasized, “The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.”
The following chart is reprinted from our November 11, 2013 weekly comment A Textbook Pre-Crash Bubble. What is important, in my view, is not simply the log-periodic structure, but the broad array of additional classic speculative features that emerged as the market approached its recent highs.
A few months ago, Bill Hester examined a century of price data, and observed that the non-overlapping periods most closely correlated with the past 5-year trajectory of the S&P 500 were the advances preceding the 2007, 2000, 1987, 1937 and 1929 market peaks. This shouldn’t be a surprise – the past 5-years have largely resembled a diagonal line, as did the advances to those extraordinary market peaks. Diagonal lines always have a nearly perfect correlation even if there is some amount of variation along the way.
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