Prediction for the Market

Hi all.

Normally it would be time for Friday Tech Files but in these turbulent market times I wanted to spend my time today analyzing the recent market activity. Regular readers will know that I called the market drop just a couple days in advance and moved everything not in the finance wonk portfolio to cash - so what do we do now that the market has bounced? (for more on a review of my results see my shameless "I was right" post)

Well, there are two things I'm looking at right now: imputed volatility and investor behavior. Imputed volatility (measured numerically in indexes like the VIX index) is a neat measurement derived from options pricing of the expected market volatility implied in the prices people are trading options at. It represents the markets current thinking about volatility. A couple years ago I did a historical study (20 pages and unfortunately not something I can publish as it contains proprietary data) on implied volatility.

Turns out high VIX scores precede jumps UP in the markets, but not drops. That is to say that the whole market feels the positive glow as people decide a slump is over and start to invest, but that right up until a drop everyone is predicting things are fine. During this last week runup the VIX dropped off a cliff as investors shut their eyes to risk and jumped in the market. That's actually a bad sign.

The second thing I'm watching is investor behavior. During the last 4 months or so of climb before the drop we saw a pattern where investors would have little response to bad news, then pump up shares when anything could be interpreted as reducing the risk of inflation. Clearly nobody felt a downturn was a threat and inflation was the only concern.

The drop hit shortly after the first serious concerns about recession surfaced (link to post of mine just before drop). It was these concerns which drove the market down.

This week investors returned to the thought that inflation was the only risk. The Federal reserve altered their language and specifically acknowledged that the economy faces risks and yet the market went up. Meanwhile the implied volatility guages dropped, showing that investors were looking at this recent drop as a chance to throw their money in the market and look smart... a sure sign we're near the top.

Meanwhile the next few quarters will see reduced earnings growth, much of the subprime market failures effect on the economy has yet to unwind (KB homes profit down 84% already!), and commodity and labor inflation will be squeezing prices. At some point all these chickens have to come home to roost.

In my usual fashion I'm going to bravely and uncertainly call the future and invite your feedback: I believe that a year from now the market will be less than 5% above where it is now - possibly FAR below that. Why is this an important point? Because you can make 5% risk free in a good bank account (like at E-trade) so anything lower from the market means holding cash is smarter.

The market may go up a bit from here as you get a rush of the "last in" people piling into the market, and there will be downdrafts from hedgies unwinding their leverage, but ultimately I'm keeping my pile of cash.

Weekly look ahead

The seasons earnings are tapering off this week, and profit growth has slowed but is still relatively healthy. Healthy enough that investors seem content that companies will continue to grow if left alone.

The healthy but moderating growth explains some of the strange recent market reactions. Week before last I predicted a huge upward jobs revision and also that it would drag the market down, not push it up (here, below the break). We have been seeing a market that wants the market to plod along without good or bad news, really. Good new sends the market down because it increases the risk of inflation and action from the Fed, bad news can send the market down if it suggests pain to corporate profits.

Unfortunately this week will be full of news (check out the economic calendar graphic below). Most certain to cause waves: Fed Chairman Ben Bernanke will be performing his semi-annual reports in front of the Senate (Wed) and House (Thu). Together will all the economic reports out this week Bernanke's testimony guarantees that investors will have a laser-like focus on inflation. Expect signs of inflation to invoke selloffs in the market.

Finally let me counter the general journalistic sentiment on what happened friday. I don't think the rise in oil had much to do with the market decline friday. I have been conducting analysis on this and for one thing the stocks that do well with increased gas prices did not rally at all. I believe friday was a general profit-taking which suggests people will have money in their wallets and be looking for openings to invest.