Fasten your seat belts as market’s wild ride continues
There’s just as much chance the stock market will soar in the second half of this year as plunge.
That at least is the conclusion based on an analysis of the historical relationship between the stock market’s first-half-of-theyear performance and how it does in the second. That relationship turns out to be largely random.
Some may consider this good news because it means the stock market in the second half of 2016 isn’t doomed to experience the big swings suffered so far.
Yet others may be disappointed, as these odds mean we have no reason to expect the stock market to perform any better between now and December than it has been.
One thing is clear: The stock market had a roller-coaster ride over the past six months.
After turning in the worst start to a calendar year in U.S. history, the stock market turned in a strong rally in which the Dow Jones industrial average rose 4% above where it started 2016.
It experienced another strong correction in late June, following the global shock over the United Kingdom’s vote to leave the European Union, but then came roaring back as the first half of the year came to a close.
At the halfway point of the year the Dow is up 2.9% and the Nasdaq is sporting a 2.6% loss.
Perhaps the strongest bet we can make based on the historical relationship between the first and second half of the year is that this roller coaster is likely to continue.
Why? Because periods of high volatility tend to be clustered together.
Many analysts use an airline analogy to describe this tendency. Periods of airline turbulence are clustered together, so pilots turn on the fasten-the-seatbelt sign at the first sign of it — and then turn it off after the flight has been calm for a while. Bracing ourselves for above-average volatility as we begin 2016’s second half is the functional equivalent of fastening our seat belts.
Searching for patterns in the relationship between stocks’ firstand second-half performance can also increase our understanding of how the markets work in general. The reason second-half per- formance is randomly related to its first-half returns is that the stock market looks forward, not backward.
“The behavior of the stock market is a function of the consensus expectation among investors about the future. What changes the market’s level are changes in that consensus, and the only thing that changes it is new information — which by definition has nothing to do with what came before,” says Law- rence Tint, chairman of Quantal International, a firm that conducts risk modeling for institutional investors.
To illustrate, Tint mentions a common response to the news that the U.K. voted to leave the EU: We should be making portfolio changes in response to Brexit.
“But this betrays a misunderstanding about the markets,” he argues. “It is too late to make any such changes based on what has happened, since the British referendum is already reflected in the market’s current level.”
“What will change the market going forward,” he continues, “will have nothing to do with the fact of the British referendum itself but with developments yet to come — the terms of the exit that Britain and the EU negotiate, for example. Only if we have special insight and can forecast these future developments better than the consensus should we now make changes.”