Unexpectedly Intriguing!
March 7, 2018

From time to time, we take on the specific challenge of forecasting where the S&P 500 will over an extended period of time.

That's usually because of a limitation of our dividend futures-based forecasting model, where because we use historic stock prices as the base reference points from which we project future stock prices, we occasionally have to deal with the echoes of past volatility and their effect upon our model's projections. Most often, we know well in advance, up to 12-13 months ahead of time, when what we call the echo effect will affect our model's projections by skewing their accuracy for the duration of the echo event, where we've experimented with various methods over the years to cope with the issue.

A little over a month ago, we were caught by surprise when we realized that our model had picked up a short term echo that would throw our model's projections of the S&P 500's likely future trajectories off by somewhere around 100 points, which is a direct consequence of the breakdown in order that occurred in the market beginning after 29 December 2017. A new echo had formed, where we would have the opportunity once more to generate a new manual forecast for the S&P 500 over a period of at least four weeks.

When we take that step, we call it a "red-zone" forecast because we are basically drawing red boxes on our spaghetti forecasting charts generated by our standard model of how stock prices work to indicate the range into which we expect the S&P 500 will close each day during the period of the manual forecast. We posted that emergency red-zone forecast before the market opened on 7 February 2018, where we also laid out our assumptions:

From the end of trading on Friday, 26 January 2018 when it closed at its all time high of 2,872.87 to the market close on Tuesday, 6 February 2018 when it rebounded from the previous day's crash to close at 2,695.14, we estimate that the S&P 500 lost over $15.9 trillion of its market capitalization. Since that's a lot of money to have so suddenly evaporated over the last seven trading days, we imagine that a lot of investors are asking if Tuesday's rebound marks the end of the market carnage.

Nobody will know the answer for sure for some time yet, but we do see an intriguing possibility that it has. If we're right, and the sudden, sharp drop and highly volatile trajectory of stock prices has indeed all been part of a Lévy flight event, it may indeed be over except for some higher-than-typical levels of daily volatility, because it would appear that investors have completed shifting their forward-looking attention from the distant future quarter of 2018-Q4 all the way back to the current quarter of 2018-Q1, since such shifts in forward-looking focus are the drivers of this kind of volatility in our dividend futures-based model of how stock prices work.

Alternative Futures - S&P 500 - 2018Q1 - Standard Model with Connected Dots Between 7 February 2018 and 6 March 2018 - Snapshot on 6 February 2018

Our alternative futures chart above updates and modifies the version we first presented back in the early hours of Monday, 5 February 2018. Let's talk through the updates:

  • The crash of stock prices from Friday, 26 January 2018 to Monday, 5 February 2018 has confirmed for us that our model's spaghetti chart-like projections of alternate trajectories that the S&P 500 might take assuming investors focus their forward-looking attention on specific future quarters is showing the effects of a new volatility echo, which runs in the period from 7 February 2018 through 6 March 2018. The echo effect is a consequence of our model's use of historic stock prices from 13 months, 12 months and 1 month earlier in time as the base reference points for its projections, where the echoes of past volatility affect its forecasting accuracy.
  • To get around that limitation, we've developed two new "red-zone" forecasts using our "connect the dots" approach to dealing with the echoes of past volatility (in this case, from the one month earlier period) on our model's projections. The first assumes that investors will keep their forward-looking attention on 2018-Q1 until the dust settles, which is represented by the solid-red line box shown on the chart above. The second assumes that investors will shift their attention to the slightly more distant future quarter of 2018-Q2 sometime during the next four weeks, which is shown as the dashed-red line box on the chart above.
  • Right now, the width of the red-zone forecast boxes are shown with the same +/-3.0% margin of error range that we use for our standard forecasts, which assume "typical" levels of day-to-day stock price volatility. Given the recent outbreak of chaotic volatility however, we might see stock prices move outside of those ranges without necessarily being the result a definitive shift in the forward-looking focus of investors.

Our red-zone forecast that began on 7 February 2018 extended through yesterday, 6 March 2018. The following chart shows the results of our manual forecasting exercise.

Alternative Futures - S&P 500 - 2018Q1 - Standard Model with Connected Dots Between 7 February 2018 and 6 March 2018 - Snapshot on 6 March 2018

In all, there were 19 trading days in the forecast period from 7 February 2018 through 6 March 2018. For the red-zone forecast indicated by the solid red line box, the S&P 500 closed within its perimeter on 17 of 19 days, with 89% of the observations falling within the forecast range. For the red-zone forecast indicated by the dashed red line box, the S&P 500 closed within its perimeter on 18 of 19 days, or just shy of 95% of the observations falling within the forecast range. The results are about on par with what we achieved during three separate periods in 2017.

We've indicated in the chart above that we would draw the forecast range differently today, and truth be told, that text has appeared on all the intermediate charts that we've presented beginning with the one we featured back on 12 February 2018. Based on what we knew at that later date, we would have drawn the red-zone forecast boxes to cover a longer period of time into the future, and we would draw them to be wider to accommodate the elevated level of volatility that was clearly evident in stock prices.

And now, we've reached the end of the latest red zone forecast for the S&P 500, where strange times for the market appear to lie ahead, at least if the news headlines over the past week and a half are any indication....

Monday, 26 February 2018
Tuesday, 27 February 2018
Wednesday, 28 February 2018
Thursday, 1 March 2018
Friday, 2 March 2018
Monday, 5 March 2018
Tuesday, 6 March 2018

At The Big Picture, Barry Ritholtz found that numbers of positives and negatives for the U.S. economy and markets in the final week of February 2018 weighed in favor of the negatives.

We'll pick up the stock ticker tape again on Monday, 19 March 2018. By then, investors will have definitively shifted their forward-looking focus away from the current quarter of 2018-Q1 to .... Well, if you knew that, you would have a pretty good handle on where stock prices will go next, wouldn't you? We'll just have to see how much of a wild card the trade picture is for generating noise in the market!

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