An article in Business Insider suggests that after a 40% run up in stock prices the market will suffer a correction. Sadly this conclusion is based on close reading of a 90 chart of the Dow. Thus one is suspicious.

Putting this to a test one finds that the market gains .024 per day in all days since Oct 1929. But after a 40% gain in the previous 252 days the return nearly doubles to .043 per day. During days without the prior 40% return the average day only gains .023%. Full summary results:

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Rocky Humbert comments:

That article demonstrates many flaws, including the way the question was posed and the fuzziness of the outcomes.

Here's a different spin: What would happen if you bought the Dow Jones only after a 40% annualized gain, and held the position for the next 90 days? The results:
1933: +18%
1935: +10.9%
1943: +4.9%
1954: +6.7%
1983: +8.1%
1986: +4.0%
1987: -23%
1996: +3.2%
1997: +3.5
1999: +0.4%
[Data do not include dividends]

(There are 14 data points in the article versus 10 above. The difference is due to my having an open position and not double-counting a re-entry.)

Conclusion: Buying after a 40% rally provides returns that are better than long-term drift unless you get caught in a market crash. Hence, if history is predictive, it's actually a fine time to go long and pay 1% premium to buy some out-of-the-money puts to attenuate the tail risk. Applying a T-test is above my pay grade.

I interpreted the article as arguing that an initial move over a 40% ROC had bearish predictive value — and history suggests that it does not. Re-entries were not mentioned…One should also consider the source of the article: Business Insider picked it up from a website aptly called FinancialArmageddon.com whose author (Michael Panzner) wrote the eponymous book, Financial Armageddon (2008) and more recently, When Giants Fail (2009). I have not read either book, but I'm told that his most recent tome doesn't mention Eli Manning. 

Rocky Humbert, quantitative analyst, speculator and master chef, blogs as OneHonestMan.


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