November 20, 2017

Investment Theory

HHHHHHHHHHHH: Is there a message in there?

By Victor Haghani and James White 1

The 12-month winning streak of the stock market through the end of October reminded me of a Friday afternoon on the Salomon trading floor in early January 1987.2 The markets had closed, the day’s trades were confirmed and we were sitting around discussing weekend plans. In walked six and a half feet of the most enthusiastic and well-liked of all the Salomon MDs, a man who believed nothing was impossible.3

“How about that stock market! Up every day this year so far – six days in a row! I think it’s going to be up every day this year. What odds would you guys give me on $1,000 that I’m right?”

We perked up. There were another 245 trading days left in the year, and even if we assigned an 80% chance to the market being up each day, the probability that it would be up the next 245 in a row was about a trillion trillion to one.4

We agreed to syndicate the risk among five of us, and we offered him odds at 5,000:1, but only on $50. He scoffed and walked away dissatisfied – no bet.5 Then, as if to show us that anything remotely possible might just happen, we watched the Dow go up every day for the next seven days, an 11% rally altogether, until the streak finally ended on the 14th day.6

Bloomberg just published a short note we wrote (here) that takes a more in-depth look at stock market streaks. We reviewed 150 years of US stock market history and found that there have been six streaks of 12 months or longer. While it’s very likely we would witness one streak of 12 or more winning months in a row, it is highly unlikely to see six or more such streaks if the stock market followed a random walk, with each month’s return independent of prior returns.

What history suggests is that, in the short to medium term, the stock market exhibits momentum, or trending, which likely goes hand-in-hand with longer term mean reversion.7 As you know, at Elm we believe it makes sense to take account of valuation and momentum in the asset allocation decision. While the past is not necessarily indicative of the future, our review of stock market streaks does not contradict our view of market behavior.

  1. Victor is the Founder and CIO of Elm Partners, and James is Elm’s CEO. Past returns are not indicative of future performance. This not is not an offer or solicitation to invest.
  2. My memory of these events is a bit fuzzy, but the main aspects of the story are accurate.
  3. For those readers who were at SB at the time: OG.
  4. And it took a good few seconds for our HP12C to do that calculation.
  5. We didn’t think about it in these terms at the time, but it turns out that this was a positive expected utility bet for us, even assuming the chance of us losing was 0.01%, rather than 2.0e-24.
  6. Even more unlikely than the stock market’s 13-day winning streak at the start of 1987 was the Monday later that same year, on October 19th, when the stock market fell by over 20% in one day.
  7. You may be wondering what happened after each of the five market winning streaks of 12 months or more ended. The average total return following each of those five streaks, starting one month after the streak ended, was about 15%. It was positive in four out of five of those cases. While five data points do not produce a result of statistical significance, this result is not inconsistent with the hypothesis that the stock market displayed positive momentum or trending in the past.