A Little Historical Perspective

For my inaugural market-centric post of 2011, I thought that I would address a question many of us are asking:  Just how much further can this rally extend?  As most of you know, I've been highly skeptical of this rally since late October of last year.  To be sure, I've been surprised at the equity market's resiliency in light of the numerous economic concerns that remain unaddressed in the global and domestic economies.  Coupled with overly bullish momentum indications (RSI, compressing MACD), it is clear that we're in the euphoric phase of this leg up.  But is all too often the case in the financial markets, economic conditions and technical indicators do not always rule the day.  Sentiment and momentum have the uncanny ability to push markets to levels that make no rational sense.  That said, this is not the first time that the markets have rallied after large sell offs, so I thought it would be useful to take a look back at the performance of the S&P 500 and Dow Jones Industrial Average (DJIA) to see how they performed in prior environments.  In my opinion, this should provide a good estimate of just how far this irrationally exuberant part of the rally could go and, consequently, enable us to position our portfolios to take advantage of the conclusions.

Using data beginning in 1950 for the S&P 500 and 1928 for the DJIA, I looked at the scale, frequency, and duration of rallies after a year that saw negative returns.  As I was most concerned with relief rallies, I excluded those years where a negative annual return was followed by another negative annual return since the current rally did not fit this profile.  Other than this caveat, the data analysis was pretty straight forward.  Here are the highlights:

S&P 500

1.  The average duration of a relief rally is 1.98 years.  The longest relief rally on record lasted 8 consecutive years and was seen during the 1980s.

2.  31% of all relief rallies have lasted more than 2 consecutive years, with a 3 year duration being the most common period among these.  Only 15.5% of rallies have lasted more than 3 years.

3.  A 2 year rally averages a cumulative return (ex-dividend) of 45.30%.  This is about 6% higher than the 39.24% that's been seen so far, but well within the 56.70% to 29.30% historical range.

4.  The average total return associated with a 3 year rally is 51.1%, which means that an annual return of about 6% is seen during that time.  Applying this to current levels, the S&P 500 would be set to hit 1,333.

5.  Interestingly, no rallies of exactly 4, 6, or 7 years were seen.  However, a 5 year rally has been seen twice.

DJIA

1.  The average duration of a relief rally is 1.875 years.  The longest relief rally on record lasted 9 consecutive years and was seen during the 1980s.

2.  26.8% of all relief rallies have lasted more than 2 consecutive years, with a 3 year duration being the most common period among these.  Only 15.5% of rallies have lasted more than 3 years.

3.  A 2 year rally averages a cumulative return (ex-dividend) of 36.50%.  This is about 4.50% higher than the 31.92% that's been seen so far, but well within the 63% to 19.70% historical range.

4.  The average total return associated with a 3 year rally is 51.3%, which means that an annual return of about 14.8% is seen during that time.  Applying this to current levels, the DJIA would be set to hit 13,287.

5.  With the exception of the 1980s bull run, no DJIA rally has lasted more than 5 years.  There is only 1 instance of 5 year rally.

Aside from the interesting trivia associated with these numbers, I think there are a few takeaways that are worth noting.  First, it is clear that this rally is getting long in the tooth.  Yes, there have been instances where rallies have extended more than 2 years, but the probability of this occurring is quite low.  Second, despite the huge year 3 returns implied by the DJIA numbers, the risk of missing a significant amount of return in 2011 is fairly small since the majority of the cumulative return is seen during the preceding 2 years.  This doesn't mean that one should necessarily stay out of equity, but it does suggest that the cost of remaining in cash should be dramatically reduced in 2011.  And with the Federal Reserve likely at the end of its QE program, another stimulus-induced rally is highly improbable.

Until later.....