Time For A Correction

As we write this at 12:00 PM Eastern Standard Time in the U.S., the S&P 500 is up a bit over three points from its previous day’s closing value of 1,280.26, and has been up most of the morning. The market has been performing largely as expected over the past several months, rising 100 points in a very orderly fashion since the end of November 2010. And it’s a really nice day outside, so we were going to spend some time there.

And yet, Barry Ritholtz’s Spidey Sense is tingling….

We think he’s right. Here’s how we see it.

In December 2010, our indicator of distress in the stock market, the price-dividend growth ratio, spiked:

S&P 500 Trailing Year Price Dividend Growth Ratio, January 1871 Through December 2010

It has since backed off, however a spike in the price dividend growth ratio is well correlated with short-term troughs in stock prices. Here are the updated statistics we have for that:

Coincidence of Price Dividend Growth Rate Spikes with Market Troughs Data Item Number of Occurrences Percentage of Total Total Number of Spikes 323 100.0% Number of Spikes Exactly Coinciding with Trough 78 24.1% Number of Spikes Within One Month of Trough 192 59.4% Number of Spikes Within Two Months of Trough 263 81.4%Since January 1871, whenever the price-dividend ratio has spiked in a given month, stock prices passed through a trough (a short term bottom) 24.1% of the time during the same month as the spike, 59.4% of the time within one month of the spike and 81.4% of the time within two months of a spike.

Because there is no trough in average monthly stock prices in the months leading up to December 2010, that correlation suggests that there is a very high likelihood of one occurring by the end of February 2011.

Meanwhile, we don’t see any significant deterioration in the fundamentals underlying today’s stock price valuations, which indicates to us that the market will soon go through a short term correction, with stock prices rebounding quickly afterward.

Consequently, we view today’s upward movement in stock prices as a selling opportunity. We would expect a buying opportunity to follow in the near future.

And since we missed out on enjoying Friday to produce this post, we’ll take Monday off and see you on Tuesday!

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