The Improbable Streak

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Investing

Jaipal K. Tuttle, PhD | March 17

This post is a cutdown version of a longer paper on the probability of the recent streak in the US equity markets. For the complete paper please download here.

To say that the stock market rally since election night last November is unusual is an understatement. Flying in the face of rising national and geopolitical tensions, uncertainty about policy, and general instability, the markets have been cooking. In the 76 business day span following the election of Donald Trump (November 8th, 2016 to March 1st, 2017) the US stock market rallied strongly while experiencing near record low volatility. The statistics are astonishing. During that span, the Dow Jones Industrial average took out twelve consecutive record days - last time that happened Ronald Reagan was still president. During the same period, the S&P 500 lost more than 50 basis points on only three days.

Defining the Improbability

We have calculated that the probability of the streak in the S&P occurring is, P{3||76<−50bp}=1/906. To put that into perspective, it is the equivalent of you getting a full house or better when playing one hand of five-card poker every 76 business days. There is no trading cards and we are not talking about other players hands either… just about you sitting at a table where one hand is dealt every 76 business days. You would be amazed if you were handed a full house or better!

An equally astonishing aspect is how much the anatomy of the the run-up diverges from normal. When we look at the daily gains, we see that average increase is nearly 4 times the normal rate (15.8 basis points vs. 4.2 basis points per day) - remarkable.

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Figure 1 Histogram of daily returns of SPY November 8th, 2016 to March 1st, 2017. Source: Bloomberg

This is a nearly unmatched statistic. It was as if all the risk had been sucked out of the marketplace - a statement that is corroborated by the VIX index declining to near record lows during the same time period.

Streak in Historical Context

Now comes the hard part. The historical company for similar market behavior puts this run-up in dubious standing. We can start by looking back at the past 25 years. A returns streak like this has only been seen once before: That was a streak ending November 8, 2006 during the peak of the housing bubble and less than a year before it began to collapse. The next best equivalent is the streak of twelve record closes in the Dow in early 1987 which, of course, was the year we also saw the Dow drop 20% in a single day on October 19th - otherwise known as Black Monday.

So how will history look back at this record breaking streak of stock market moves at near record low volatility amongst what seem to be unfathomable external conditions that could yield an exogenous shock at any moment? Perhaps the totally unexpected will occur and this will all have a fairy tale ending. Perhaps not. None of us can know the future before the fact. One thing we do know with certainty is that someday another crisis will occur. So what can we do?

Probable Preparation

The crucial part is that we believe exposure to volatility should always be present in an investor’s portfolio. We believe the next crisis is unlikely to give us enough fair warning in time so we can all go out and buy volatility at the last minute. However, in this instance the improbable streak we have just witnessed may actually be that fair warning. Only time will tell.

Click here to download the complete paper on the improbability of the current market streak.

To learn more about the truth behind asset correlations and volatility, click here for our complimentary eBook "The Five Myths that Put Portfolios at Risk: Revealing the truth and improving investment outcomes using options."