Has the Australian Stock Market…

… ever seen anything quite like this?

I updated my “Stock Market Seismometer” (click on the separate tab above for details) for the first time in many months. I have to say, the results shocked me. Over the course of 2011 the Australian stock market slid down even further into “oversold” territory. As we head into 2012 things have never looked so bleak. Or maybe 2012 will be the year of the rebound? I expect at some point growth will move back to its long term trend, but when that will start to happen is anyone’s guess.

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Is this the beginning of the double-dip?

I’ve just updated my Stock Market Seismometer (see separate tab above) for the month of January 2010, and a disturbing new trend is starting to emerge.  Having spent most of 2009 digging itself out of a massive hole, the market is now showing every sign of turning around and heading south again.  What I thought might be a sustained “V” shaped recovery could actually be the middle of the “W” shaped collapse that many commentators feared.

Or is it still too early to tell?   Of course, if I’d been following my own advice, (I’m not qualified to give YOU advice) I’d have taken my money out of the market months ago…

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NOT to be used for FINANCIAL ADVICE. For academic interest only.

The “V-shaped recovery” continues

…or is it more like a bullet ricocheting off the floor, about to hit us in the cojones?

Sixteen days late, but tonight I finally got around to updating my “Stock Market Seismometer” (see separate tab above) for the period ending July 2009.  It was a relief to see the control chart has moved out of “extremely over-sold” territory and into the “highly over-sold” range.  I had to go to all the trouble of changing the font colour from red to orange!  The index is now back to where it was in October last year, and continues its inexorable march upwards.

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NOT FINANCIAL ADVICE.  For academic interest only.

Is the worst of the GFC really behind us?

The decision by 10 US banks this week to repay their TARP money and escape the clutches of the Obama remuneration busybodies more or less confirms that the financial crisis is over.

Alan Kohler, “Pricing out the crisis”, Business Spectator, 11 June 2009

Alan Kohler is an Australian business journalist that I have a lot of time and respect for.  So it was interesting to read him confirm what my own crude Stock Market Seismometer has also been indicating over the last three months… perhaps, financially speaking, things are returning to a state of normality?  I’m not qualified to give financial advice, but I’m quietly optimistic that the worst of the Global Financial Crisis is behind us.

Now there’s only the swine flu pandemic currently sweeping Australia to worry about!

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That Really Is A Lovely Bottom

I’ve updated my Stock Market Seismometer (see separate page tab above for details) for the month ending April 2009.  I don’t work in the finance industry, and I’m not qualified to provide financial advice, but it seems that perhaps (just perhaps) the stock market has hit the bottom.  I’ll very likely live to rue that prediction.  The pundits say it’s a dead cat bounce with a lot worse to come.  But over the last couple of months the Australian Stock Exchange All Ordinaries Index has, at least according to my crude measure, started to reverse out of the massively over-sold territory.  There’s a long way to go before I’d describe the stock market as being anything like “in control”, but at least we’re now heading in the right direction.

stock-market-seismometer-2009-04

What an amazing roller-coaster ride.  I’m feeling a little bit woozy from it all.

As an aside – I can’t give you financial advice, but I can at least take my own.  I’ve decided that now is as good a time as any to put a bit of my own money into a managed fund.  So I guess we’ll see what happens.

The Stock Market: Beautiful One Day, Perfect The Next (Part 2)

Several weeks ago I used simple conditional probability to formulate an optimal investment strategy:

…put your money into the market only if the last month was up.  If the prior month was down then keep/take your money out.  Lather.  Rinse.  Repeat.  In theory this strategy should work about 65% of the time.  If, on the other hand, you put your money into the market when the previous month was down (or sideways) you’ll have just 49% chance of making a profit.
The Stock Market: Beautiful One Day, Perfect The Next

The purpose of the analysis was not, and is not, for anyone to use as financial advice (which I am not qualified to give).  It was for academic interest only.  And this remains the case.  However, I wanted to measure how the theory would “work” in the “real world”.

I decided to test my theory over a timeframe covering the last five years.  This has been an interesting period on the Australian Stock Exchange (ASX) to say the least.  Several years of a huge bull run completely wiped out in 12 months by the Global Financial Crisis.  I wondered how my investment strategy would hold out against that kind of shenanigans.  Using monthly average ASX All Ordinaries adjusted close indexes (AORD) I invested a theoretical $10,000 in the market at the beginning of January 2004.  Strategy 1 is my optimal strategy: put money into the market only if the previous month was up.  If the previous month was sideways or down then pull your capital out.  Strategy 2 is the control: capital remains in the market.  For example, the first six months of capital growth using Strategy 1 and Strategy 2 would look like this:

ASX AORD
(adj close)
Monthly Δ Strategy 1
(optimal)
Strategy 2
(control)
Start $10,000 $10,000
Jan 2004 3283.6 -0.7% $9,932 $9,932
Feb 2004 3372.5 2.7% $9,932 $10,201
Mar 2004 3416.4 1.3% $10,062 $10,334
Apr 2004 3407.7 -0.3% $10,036 $10,308
May 2004 3456.9 1.4% $10,036 $10,456
June 2004 3530.3 2.1% $10,249 $10,678

Between January 2004 and October 2008 there were 58 months in total.  For 39 of those months the ASX All Ords went up, and the average percentage movement of these “up” months was +2.6%.  In the remaining 19 months the index went sideways or down, and the average percentage movement of these “flat/down” months was -4.1%.  This has obviously been skewed by the market meltdown over the last year or so and the last two months in particular.  We’ve seen some horror months on our Stock Market lately.  For example the AORD fell fell a massive 11.3% in January 2008 (looking back this was the death of the coal mine canary), 11.2% in September 2008 and then fell 14.0% in October 2008.

But what if you had used my investment strategy over the last five years?

Well the bad news is that Strategy 1 quite significantly underperformed Strategy 2 during the bull run.  A few relatively minor flat/down months here and there meant that capital was pulled out and very healthy returns would be missed during the subsequent month.  But the good news is that Strategy 1 protected the investor against the financial meltdown.  By October 2008 the initial $10,000 invested using Strategy 1 in January 2004 was worth $14,508 (average growth of 8.0% p.a. compounded) vs. $12,047 (3.9%) for Strategy 2.  So the really good news is that Strategy 1 outperformed the market by more than double.

Woo hoo!

Enough hubris.  Of course things are a lot more complicated in the real “real world”.  For a start, history is no guarantee of future performance.  Strategy 1 might look good on the spreadsheet but carries more risk.  Also, the success of Strategy 1 over Strategy 2 assumed no brokerage fees.  And it took no account at all of dividend payments or relative tax consequences.  Under the weight of these considerations Strategy 1 doesn’t look quite so “optimal” after all.

But an interesting result nonetheless.

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NOT FINANCIAL ADVICE.  FOR ACADEMIC INTEREST ONLY.

The Stock Market: Beautiful One Day, Perfect The Next

This planet has – or rather had – a problem, which was this: most of the people living on it were unhappy for pretty much most of the time.  Many solutions were suggested for this problem, but most of these were largely concerned with the movements of small green pieces of paper, which is odd because on the whole it wasn’t the small green pieces of paper that were unhappy. – The Hitchhikers Guide to the Galaxy

By all reports we’re at the edge of a precipice, staring forebodingly down into a pit of total economic ruin.  Banks are falling (or frozen with fear), credit has dried up and the world’s financial markets lurch up and down wildly from one day the next.  It will be interesting to look back on this post in a year and reflect on how it all turned out.  Or maybe by then there will be no blogs for humanity to turn to… we’ll have abandoned civilisation and returned to the trees.  In fact you could argue that the The Hitchhiker’s Guide to the Galaxy had it right: even moving to the trees was a mistake.  We should never have left the oceans.

Regardless, money troubles are weighing on our minds at present.  So let’s take a break and have a light hearted look at the Stock Market from a statistical point of view.  The question I’ll pose is: based on historical data what would an optimal investment strategy be? Of course far better brains than mine have trained their thoughts on this topic before.  I won’t be breaking any new economic theory.  But the analysis below is simple and fun.  Importantly, I must stress that it is NOT financial advice (which I am not qualified to give).  It is for academic interest only.

But first we need some data.

The Wren Investment Advisors website has made long term time series data on various financial market indicators available for download.  Among those is the monthly average Australian Stock Exchange All Ordinaries Index (AORD) commencing from January 1875.  The history of the AORD over the last 133 years looks a little bit like this (plotted on a log scale):

ASX All Ordinaries, Monthly Averages, 1875 to 2008

ASX All Ords Monthly Avg Jan 1875 to Jul 2008

Between February 1875 and July 2008 there were 1,602 months, of which 930, or 58.1%, recorded an increase over the preceding month.  (I had to leave January 1875 out as I don’t know if it was up, down or sideways compared to December 1874).  So you could argue that it doesn’t matter when you invest.  You have better than even odds that the next month will be better.  Of more interest, perhaps, is when we look at a month’s average AORD index to its preceding month, and then the preceding month’s index compared to the month that came before that.  If we define:

Event A: Monthly average AORD index moved higher over the preceding month (e.g. December 2005 was higher than November 2005).

Event B: Preceding monthly average AORD index moved higher over the month that came before that (e.g. November 2005 was higher than October 2005).

Similarly A’=Not A (went down or sideways) and B’=Not B.

The possible outcomes can be expressed as a 3×3 contingency table:


month n UP month n DOWN total
month (n-1) UP A∩B A’∩B B
month (n-1) DOWN A∩B’ A’∩B’ B’
total
A A’ Σ

For example the monthly average AORD index for December 2005 was higher than November 2005 which in turn was higher than October 2005.  This is an Event A∩B (A “intersection” B).  I counted 602 of these events in the 1,601 months between March 1875 (this time a minimum of three months of data is needed to start) and July 2008.  Similarly, November 2007 was lower than October 2007 but which was higher than September 2007.  This is an Event A’∩B.  I counted 328 of these events.

If I got everything right then the completed contingency table of counts looks like this:


month n UP month n DOWN total
month (n-1) UP 602 328 930
month (n-1) DOWN 328 343 671
total
930 671 1,601

Or, in terms of frequencies:


month n UP month n DOWN total
month (n-1) UP 0.376 0.205 0.581
month (n-1) DOWN 0.205 0.214 0.419
total
0.581 0.419 1.000

Which leads back to the original question: based on historical data what would an optimal investment strategy be?  One possible strategy would be to base our investment decision on the market’s average performance last month.  Looking at the available data, the chances that the stock market (as measured by the monthly average AORD index) will be up this month, GIVEN that it was up last month, is derived using the law of conditional probability:

P(stock market moves up this month, given that it moved up last month)

= P(A|B) = P(A∩B) / P(B) = 0.376 / 0.581

= 0.647 (i.e. just under 65%)

Interesting.  It seems the stock market is a bit like the weather.  A sunny day today means a high likelihood of a sunny day tomorrow.  Beautiful one day, perfect the next.

Going back to the remaining conditional probabilities:

P(A’|B) = 0.205/0.581 = 0.353 (down next month, given up this month)

P(A|B’) = 0.205/0.419 = 0.489 (up next month, given down this month)

P(A’|B’) = 0.214/0.419 = 0.511 (down next month, given down this month)

One optimal investment strategy therefore appears to be to put your money into the market only if the last month was up.  If the prior month was down then keep/take your money out.  Lather.  Rinse.  Repeat.  In theory this strategy should work about 65% of the time.  If, on the other hand, you put your money into the market when the previous month was down (or sideways) you’ll have just 49% chance of making a profit.

Of course things are a lot more complicated in the real world.  For a start, history is no guarantee of future performance.  Also, the success of this strategy assumes that you don’t have to pay any brokerage fees.  And I didn’t consider magnitude of movements in this analysis, only direction.  One fall of 50% is clearly going to wipe out 5 gains of 1%, for example.

But I think an interesting result nonetheless.  Did I get my analysis right?  You can download my raw calculations here.

Please feel free to send me feedback.  I hope to expand on this theme further in future blog entries.

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NOT FINANCIAL ADVICE.  FOR ACADEMIC INTEREST ONLY.  EXERCISE CAUTION IN YOUR AFFAIRS.