History suggests stocks have room to run

Stocks jumped more than 3% on Wednesday. That's a rare event that suggests more gains are ahead.

By Anthony Mirhaydari Jul 9, 2010 12:14PM

MirhaydariStocks have had a good week after posting a big 3.1% rebound on Wednesday. The action was impressive. And it's uncommon.


Big 3%+ up days on the S&P 500 don't happen very often. In fact, aside from the recent volatility, the last time stocks posted one-day gains of this magnitude was during the climb out of the March 2009 bear market low. Of course, this is exactly the type of thing that screams out for a historical analysis.


For your benefit, I went back and looked at the S&P 500 going back to 1938, when situations were similar to now. The takeaway: History suggests stocks are headed higher over the next 6 to 12 months. Now, it's important to remember that historical relationships can always change. And this is just one data point among many. But it is definitely good news.


When the S&P 500 has posted a one-day gain of more than 3% when stocks were below both their 200-day and 50-day moving averages, the average return over the next six months was 6.5%. The average return over the next 12 months was 15%. For the math geeks: Both measures were statistically significant at the 99% confidence level.


Looking back, when the stock market was in bull market mode and the economy was expanding, the instances of 3%+ up days when stocks were below their 50-day and 200-day moving averages marked excellent buying opportunities. There were a few times when the 3%+ up day signal was all wrong, such as in March and September 2008, the 2000-01 period, 1973, 1946 and 1940. But overall, this is a signal worth listening to.


It can be made even stronger by adding in a data point to reflect the condition of the economy. Recently, I talked about the strength of the 12-month change in the Leading Economic Index -- which is based on things like hours worked and interest rates -- as a predictor of economic growth. Looking only at the years in which the 12-month LEI was positive (as it is now), one can reduce the number of false positives given by the 3%+ signal.


With the LEI filter, the 12-month forward return increased to 16.8%. And although the sample size was smaller (there have been 20 occurrences since 1962), the results were still statistically valid at the 99% confidence level. There were still a few bad calls in October 2000 and early 2002. But overall, the results were very positive.




In the chart above, I have illustrated these 3%+, sub-50-day and 200-day signals along with the S&P 500. I took the 10-base log of the price to reduce the visual height and fit it all in the chart. And I've only included the signals that occurred when the LEI 12-month growth rate was positive.


The picture speaks a thousand words. And it's telling us now is the time to be optimistic about the stock market -- as it was in 1962, 1987, 1998 and 2003.


Watch me trade during the day at Wall Street Survivor.


Disclosure: The author does not own or control a position in any  company mentioned. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below. 

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