Unexpectedly Intriguing!
November 17, 2014

Today, we're testing out a super-simple method for dealing with short term echoes for our standard model for forecasting stock prices.

Echoes, as our long term readers will know, are the result of past volatility in stock prices and their effect upon our forecasting model. Because our forecasting model incorporates a number of historic stock prices in the math underlying the model, from time to time when there is a larger than typical amount of volatility in the historic data, it can result in deviation between our model's projections and the actual trajectory of stock prices. The chart below shows the base reference points in the historic data that we've used for our standard model's projections throughout 2014.

S&P 500 Index Value (Historic Data Base Reference Points) Used in Standard Model Forecast Projections, 2014

We've previously focused our efforts on those situations where the echoes of past volatility were present for a sustained period of time, which we dealt with by simply rebaselining our model to more distant base reference points in the past, which proved to be very successful. We could most certainly do that again, but we wondered if that wouldn't be overkill for the situation where there is an echo present in the data that simply won't be around for such a long period of time.

For echoes with durations of just a few weeks or less, we wondered if we could just simply draw a straight line to bridge across the gap corresponding to the echo effect upon our forecasting model. And since we have just such a situation happening right now in the stock market, thanks to a short, sudden correction from a month ago, which is coincidentally one of the base reference points we use for making our projections of the present, we thought we'd try it out.

The results are presented in our alternative futures chart below. Here, we observed that stock prices were following the trajectory associated with investors being focused on the current quarter, 2014-Q4, in setting current day stock prices. We then identified the next point in time in our projection for that trajectory that would be outside of the echo effect. And then we connected the dots....

Alternative Futures for S&P 500, 30 September 2014 - 6 January 2015 (Standard Model - Incorporates Historic Stock Price Data for Projections from One Year Prior) - Snapshot on 14 November 2014

So far, so good. We'll see if stock prices continue to behave that nicely during this week, which we also think will be increasingly unlikely as time progresses forward.

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