Unexpectedly Intriguing!
January 19, 2016

On Friday, 15 January 2015, the S&P 500 fell by 2.16%, from a value of 1921.84 to 1880.33, which in a week dominated by discussions of the odds of winning the Powerball lottery, is the kind of decline that has only a 1.75% chance of happening. Or rather, one day declines of that magnitude or greater have only happened 295 of the now 16,617 days for which we have data for the daily value of the S&P 500 since 3 January 1950!

Three of those 295 biggest drop days during the past 65+ years have been in January 2016 - a month that's barely now half over.

So why are U.S. stock prices bouncing around and dropping as much as they are?

Last week, U.S. stock prices bounced around and dropped as much as they did for two reasons: investors learned that the U.S. economy performed considerably worse through the end of 2015 than they had been led to believe, and then Fed officials couldn't get their acts together on a consistent message for shaping investor expectations for the timing of the central bank's next rate hike.

Let's update our alternative futures chart to show how the S&P 500 bounced around as investors were shifting their focus back and forth between 2016-Q1 and 2016-Q2. Update: 11:18 AM EST: Corrected actual closing value for S&P 500 on 15 January 2015 (erroneous previous version of chart available here).

Alternative Futures - S&P 500 - 2016Q1 - Standard Model - Snapshot on 2015-01-15 - Corrected

To see how that outcome came to be, let's review the major market driving events of the last week, picking up from where we left off in our previous analysis, when investors were mostly focused on 2016-Q2.

  • 11 January 2016: The S&P 500 ended up little changed, as Atlanta Fed president Jeffrey Lockhart argued that there wasn't "enough fresh data on inflation to support a second U.S. interest rate increase in January or March". Stock prices, which had been headed lower during the day as falling oil prices were leading investors to focus more upon 2016-Q1, immediately reversed on his comments, which would suggest the earliest timing of the next Fed rate hike would be in 2016-Q2.
  • 12 January 2016: The S&P 500 rose on Tuesday, 12 January 2016, to be fully consistent with a strong focus on 2016-Q2 as no other Fed officials contradicted Lockhart's comments from the previous day.
  • 13 January 2016: "Top forecaster" Stephen Stanley (according to CBS Marketwatch) came out with a statement indicating that he believed that not only was inflation on track to return, the Fed would actually accelerate the pace of its planned interest rate hikes, which perhaps explains why investors began to divert their attention away from 2016-Q2 and toward 2016-Q1, initially sending stock prices considerably lower during Wednesday, 13 January 2016. However, in the afternoon, Boston Fed President Eric Rosengren indicated that bad economic news from China might prompt the Fed to slow its planned implementation of interest rate hikes in the U.S., putting the brakes on what had otherwise been a steady decline in the S&P 500 throughout the day.
  • 14 January 2016: Speaking at the Economic Club of Memphis in the morning, St. Louis Fed president James Bullard's comments single-handedly reverse the market's decline, sending the S&P 500 considerably higher during the day, as his comments were consistent with the prospect of the Fed delaying its next rate hike until 2016-Q2 at the earliest. Like Lockhart's comments on Monday, 11 January 2016, you can tell exactly within two to four minutes of when the market got word of them as he was speaking.
  • 15 January 2016: The overnight fall of Chinese stock prices into bear territory combined with falling global oil prices to lead investors to shift their attention back more strongly toward 2016-Q1, as oil firms get set to begin reporting their earnings for 2015-Q4 while distress in the petroleum producing sector spreads into the larger U.S. economy, sending stock prices considerably lower and entirely erasing the effects of Bullard's rally. At the same time, highly influential New York Fed president William Dudley gives no indication that the Fed might consider delaying its next rate hike beyond the end of the current quarter, thus giving the S&P 500 no reason to either rally or to fall further.

The increase in stock price volatility now compared to earlier in January 2016 is directly attributable to the rather large difference in the acceleration of the growth rate of the S&P 500's dividends per share expected for 2016-Q1 and 2016-Q2. Whereas the differences between 2016-Q2, Q3 and Q4 are relatively small, meaning that shifting focus between these quarters would therefore occur within a comparatively narrow range of stock prices, that investors are now shifting their forward-looking attention back and forth between the wide difference between 2016-Q1 and 2016-Q2 means that the S&P 500 is in for a wild ride while that continues.

Analyst's Notes

We were asked a really good question on Tuesday, 12 January 2016 over at Seeking Alpha about how to interpret the short-term volatility indicated in our alternative futures chart, specifically as it relates to what it is projecting for the past and next week:

So according to the charts, is there a one week relief rally and then a second dive to 1800?

Here is our same-day response (pay close attention to the last three paragraphs):

Not necessarily. Because we use historical stock price data as the base reference points from which we project future stock prices, the trajectories shown can echo how stock prices behaved at those earlier points of time. When those prices were more volatile than is typical over a short period of time, the echo of those earlier events can show up in our projections as a short run rally or trough.

The easiest way to compensate for that effect is to take a step back and simply connect the dots for the longer term trends on either side of the deviation from those longer term trends, which should work well in this case.

For really large scale echoes, such as what we'll see later this year when we get to August on the anniversary of the "China crash", we'll go to the trouble of resetting the baseline reference stock prices that we'll use in our projections. We did that for much of the latter portion of 2015 and had better accuracy with our rebaselined model than did our standard model during the period where the historic stock prices we would otherwise have used experienced larger than typical levels of volatility.

[Although it's something of a headache to deal with, one of the advantages of using historic stock prices as we do is that we have a very good idea in advance when our standard model of how stock prices work will be most effective and when we need to adapt it to account for the echo effect.]

As for whether stock prices will take a second dive in 2016 - that will depend more upon why and when investors might shift their focus from one future quarter to another. Right now, they would have to fully shift their attention to 2016-Q1 to get down to 1800, which became less likely given Atlanta Fed president Lockhart's comments yesterday afternoon (you can tell within a few minutes of when he made them in a one-day chart!)

To get there, we think that other Fed officials would have to contradict Lockhart's comments to refocus investors on 2016-Q1, or alternatively, a spate of really bad news could do that as well, especially if it might affect the expectations for dividend payouts.

That said, once investors set their focus on a particular point of time in the future, investors should expect stock prices to generally drift downward over the quarter. If they select 2016-Q3 or 2016-Q4, we'll have a sharp rally before that drift sets in. If they select 2016-Q1, we'll have a crash before that happens. Or if they stay focused on 2016-Q2, we'll mostly likely skip both the rally and the crash and just have the downward drift.

At least, that was how we saw it back on 12 January 2016. Since then, the relative position of actual stock prices on our alternative futures chart has changed, which changes the story for a shift in focus to 2016-Q2, which would now coincide with a small rally. At least, going into this next day of trading, Tuesday, 19 January 2016.

As the data changes, so will our projections of the alternative futures for the S&P 500.

Previously on Political Calculations

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