"Kee" Points with Jim Kee, Ph.D.

For Kee Points today I want to address a question that seems to be on everyone’s minds: “Given the strong performance of stocks lately, should I invest now or wait for a pullback?” Of course that’s the wrong question to ask, as it implies that investing in stocks is a short-term timing decision rather than a long-term allocation decision. Nevertheless, given the strong run on stocks, I too have wondered what the odds are of continued gains as well as for the expected but not predictable pullbacks (~5%) and corrections (10% or more). Fortunately, I have access to a lot of research, and this sort of drill is done by pretty much every researcher on the Street. So here goes:


The S&P 500 has increased 40% over the past 18 months without a 10% correction. We’ve had one 8% and one 6% pullback, and two 4% “dips.” Usually when you have stock market gains of 25% in a 12 month period, the median correction or “drawdown” from peak to trough is 11% over the subsequent 12 months. The odds of this occurring are roughly 50/50 according to research at Goldman Sachs. And although the sample sizes are small, in particularly strong years like 2013 the odds of a drawdown of 10% or more increase to 67%. I should point out that this also implies a 33-50% chance of no correction(!). Interestingly, most of the declines during these corrections or drawdowns occur early on, and a key point to remember is that they are transient and reverse themselves fairly quickly. That’s why you have the situation where most researchers expect the market to end higher next year, and they expect a correction somewhere along the way.


Of course researchers often go about this sort of analysis in different ways. For example, a report from Morgan Stanley looks at the increase or expansion of “multiples” like P/E (price-to-earnings) ratios over a 2-year period and finds that there have been three past periods like the current two year period in which multiples expanded by 3x (most recently, from 12.0 two years ago to 15.1 at end of October). That’s only the fourth time in over 40 years that this has happened, and they find that typically the market continues to perform well in the 12 months following these times. Of course, a sample size of three is small, and the true “quants” will tell you that even 40 years really isn’t a lot of data.


Finally, the most interesting thing I saw last week: With Fed tapering talk back in the press - implying higher U.S. Treasury yields - another research question would be: “What impact would that have on stocks?” Statistically, (I have mentioned this before) the facts are that over the past 10 years, stocks and Treasury yields have had a positive correlation. That means when yields have increased, so have stocks. So rising interest rates and a rising stock market can co-exist (Goldman Sachs).