The Average Investor's Blog

A software developer view on the markets

When the Music Stops …

Posted by The Average Investor on Aug 9, 2011

About a year ago, quantitative easing 2 (QE2) was all over the news. The ever-fighting deflation, almighty Federal Reserve flexed its muscles and promised a dump worth of $600 billion to inflate asset prices. And asset prices did get inflated, including stock markets, reaching a new top in the bull run that started in March 2009.

S&P 500 during QE2

Then the music stopped. Reality took over. The S&P 500 went back again where it was before QE2 and the free fall momentum seems to be getting only stronger. Unemployment went up again. Housing market dipped again. The US lost its AAA rating. But that’s just another $600 billion righteously-spent based on the ideology set by Mr. Keynes. Still far away from what’s necessary according to prominent economists. Many of them saying in recent interviews that the economy needs more stimulus in the (ever-lasting) short term, and some of them agreeing that, of course, medium to long-term a cleaning of the deficits is needed. Of course, they didn’t mention when the short-term ends (a minor detail, since it seems to me that this short term goes back at least to 2008, probably to 2002 and likely even before). Huh?!

Can’t help but wonder: If we ask an average person on the street what would have he expected the economic situation to be after 15 years of reckless spending, debt accumulation and money printing, how often the answer will be closer to the mess we are in than to the prosperity naturally following Keynesian interventions (links needed;)?

Back in the real world, the S&P 500 is extremely oversold by any metric. I took the difference between the S&P 500 and its 50-day EMA:

linrary( quantmod )
getSymbols( "^GSPC", from="1900-01-01" )

dd = round( coredata( Ad( GSPC ) ) / EMA( coredata( Ad( GSPC ) ), 50 ) - 1, 4 )
ecdf( dd )( last( dd ) )

aa = dd[ !is.na( dd ) ]
length( aa[ aa < last( aa ) ]

plot(dd, type="l", col="blue", main="S&P 500 deviation from 50-day EMA", ylab="Deviation")
ll = rep(last(dd), length(dd))
lines(ll, col="green")

The ecdf statement gives us the percentile – 0.3624361. Ouch. The last three lines produce an easy to understand chart:

S&P 500 Deviation from 50-day EMA

While the S&P 500 has been in more oversold state on 55 other occasions (the length line in the above code) in its 61 year history, 30 of them were in the 2007/2009 crisis, and there are only 6 other distinctive events in time. Ouch.

A typical liquidation panic seems to be under way, more often associated with bear market bottoms. Ouch.

Unfortunately, when the music stops … the reality settles in.

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