Investment Postcards from Cape Town

This is a guest post by Barry Ritholtz, editor of The Big Picture Blog and author of the newly released book, Bailout Nation

With futures deep in the red, let’s take a look at how markets do after big quarters. The quarter ending September 30 saw the Dow putting in its best quarter since 1998, up a solid ~15%.

With everyone waiting for a pullback, and yesterday (Thursday] and today [Friday] viewed as the probable start, perhaps its time to review some history. What has happened historically after markets have put in record setting quarters - 15%+?

For the most part, momentum has trumped mean reversion historically. Jim Bianco crunched the numbers, and he found that “stocks returned an average of 1.33% over the month following one of these record quarters, 3.46% over the following quarter, and 9.95% over the following year”.

It is worth noting that these average returns following quarters of 15%+ performance are nothing out of the ordinary. The average monthly return over all periods in the DJIA since 1900 is 0.58%, the average quarterly return is 1.66%, and the average yearly return is 6.90%. If anything, the average returns following huge quarterly gains actually outpace the average returns during all periods.

Perhaps another way to look at it is that these record setting rallies, especially following big selloffs, are themselves a form of mean reversion.

Here’s the table of the past 15% quarters:

Source: Barry Ritholtz, The Big Picture, October 2, 2009.

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Source: Nate Beeler, Washington Examiner, October 1, 2009.

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The comments below were provided by Kevin Lane of Fusion IQ.

Yesterday’s intraday sell-the-Fed-news price reversal on the S&P 500 stalled at the area (S&P - 1,079 to 1,106 area) where the index really accelerated its 2008 sell-off (red dotted lines). This area is likely to be more difficult to overcome and may take several attempts, and thus may cap the rally a bit while the index marks time and pulls back slightly or enters a higher level trading range.

While we believe liquidity and buying power remain strong and thus pullbacks should be relatively shallow in nature, that doesn’t mean we can’t get a corrective wave of some magnitude before this sideline liquidity is redeployed. Additionally, quarter-end window dressing may keep stocks elevated or from slipping too much. However, we do believe that putting new money to work in front of this more significant resistance level poses risks. Initial support below the current S&P levels comes into play near 1,040 level (green line).

Secondary supports if 1,040 were to give way would come into play near 980/975 then 950.

Kevin Lane, Fusion IQ, September 24, 2009.

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The chart below, courtesy of Bespoke, shows that the S&P 500 Technology sector yesterday became the first of the ten major sectors of the S&P 500 Index to close above its “pre-Lehman” level of September 12, 2008. “… while the bulls will take it as a sign of the markets returning to a state of normalcy, bears will need to see a more convincing break …,” said Bespoke.

However, while the the other sector and broad market indices have gained considerably from their lows, they still have more work to do to reach the levels of before Lehman’s collapse, ranging from Financial (+36.8%) to Health Care (+11.3%). The major indices need to rise by the following percentages: S&P 500 Index +16.8%, Dow Jones Industrial Index +16.2% and Nasdaq Composite Index +5.4%.

Source: Bespoke, September 23, 2009.

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