The Risk of the Stock Market Never Went Away, It Just Seems Like it Did

Despite the very strong market since the bottom of 2009 key statistics point to very high risk especially for passive buy and hold investors. The 1-lag autocorrelation of daily arithmetic returns indicates a strong mean reversion tendency and this is verified by the Hurst exponent. Naturally, there is no reward without risk and if an investor relies on statistics may never profit but at some point the risk is too high to overlook.

The daily chart of S&P 500 index below shows a histogram of its 250-day, 1-lag autocorrelation. It is clear that before 1998 the market exhibited positive autocorrelation and thus persistence, meaning that a high would be probably followed by another high in the future. After 1998 the picture changed drastically with the autocorrelation turning mostly negative, meaning that the persistence in making new highs gave away to a mean reversion tendency. It took two years after the change in 1998 for the market to form a major top in 2000. That marked the end of “easy money” in the stock market and a new era of risky equity investments with wide swings and large drawdowns.

SPX_20131126

The persistence of the market was so strong before 1998 that it took less than two years to erase the large losses of the 1987 crash. But it took 4 years to erase the losses of the 2008 financial crisis decline. This is because the market is no longer persistent but mean-reverting. This also means that a large decline can happen any time if there is an excuse for it. And the market can always find an excuse…

Investors and traders should realize that although they are looking at one chart of the S&P 500 since 1960, there are actually two different markets in it. The risk of a mean reversion towards 1570, or a drop of about -13%, is real and supported by statistical analysis and relevant indicators, like the Hurst exponent I have talked about in previous posts. Basically, the Hurst exponent measures the degree of autocorrelation to distinguish a mean reverting from a persistent market.

Again, investors and traders should not avoid markets if they are risky because without risk there is no reward. It is just that before 1998 the risk was much lower for the same amount of reward. The world now is a lot riskier, there is no doubt about that. However, everyone should be aware about the risks involved. Especially those who still think they can invest now and collect profits after 10 years without any active management. They should remember that those who invested before the 2000 top, like in 1999, broke even on an inflation-adjusted total return basis after 12 and a half years, in mid 2012. Passive investing is an illusion for the most part and the illusion turned to a nightmare for many after 1998.

Disclosure: no relevant positions.
Charting program: Amibroker

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