By
Tom Dyson, publisher, The Palm Beach Letter
Monday, February 2, 2009
On March 15, 2006, we passed a small milestone in stock market history.
If you'd been paying attention on this date, you might have avoided the 50% stock market decline last year... or made 647% gains by betting on a rise in volatility.
Before March 2006, this landmark event had only happened three times in the previous 110 years. Every time it occurred in the past, the stock market collapsed soon after.
I documented this pattern with the help of Jason Goepfert of SentimenTrader. The signal is a three-year episode of complacency. I define an episode of complacency as a period without a fall of 10% or more in the S&P 500, marked from the highest point of the previous six months.
Ten percent corrections are very common in the markets – even in bull markets – and you can expect to see one about every two years. To go three years without one of these corrections implies a market that's so calm, you have to check its pulse to make sure it's still alive.
Usually, such a long period of calm ends quickly and painfully. Take a look:
Date
Months without a correction
Result
Feb 1966
39 months
-24% over the next 9 months
Aug 1987
37 months
-35% over the next month
May 1994
36 months
-10% over the next 3 months
Starting in March 2003, when the U.S. and its allies invaded Iraq, the market went almost five years (57 months) without a 10% correction – the longest stretch in stock market history.
"It is the complacency... that creates the trouble," Goepfert said at the time. I concluded this "fourth episode" would end in trouble because investors had never had become so lazy and complacent toward risk.
Complacency in the stock market is a bit like the weather at sea. You have long periods of blue skies and calm days interjected with fierce storms. The longer the calm weather lasts, the more cargo the shipping companies dare to load on their vessels. After five years of uninterrupted fine weather, some ships carry so much cargo, their railings barely rise above the water.
No one knows when the storm will hit, but after five years of calm weather, it's a certain bet many ships will sink when it comes.
This time, it took more than 18 months for the market to collapse after the signal flashed. But when the storm finally hit, there was a catastrophe at sea. The VIX volatility index rose 647% from 11.98 to 89.53 between March 2006 and October 2008. And the S&P 500 fell 53% between October 2007 and November 2008.
We just had the longest spell of stock market blue skies in 110 years... so it may be a long time before we see this signal flash again.
But the next time you notice a three-year period without a 10% correction in the stock market, you should bet there's trouble around the corner. Don't forget about it. It could save you from huge losses some day.
Good investing,
Tom
P.S. Jason Goepfert's website, www.sentimentrader.com, is a fantastic source for monitoring stock market sentiment. Steve Sjuggerud and I use it all the time. If you like to trade against the crowd, you should check it out.
Editor's note: Tom Dyson is a regular contributor to DailyWealth, a free investment newsletter focused on the world's best contrarian opportunities. We write with a simple belief in mind: You don't have to take big risks to make big money with your investments.
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