How to Measure The Potential Upside of the Stock Market
Conventional risk measurement metrics fail to tell us anything about the probability of loss. Most departments will say that’s not their job but if it could be measured it would add an element to that analysis that would be invaluable to senior management. To do this, we need to have confidence in a method that accounts for all the possible forces involved. This may be ambitious but let me show you how I can do it for the S&P 500.
The S&P in the short term is not really driven by supply and demand conditions since those change only slowly as a function of earnings, long term investor preferences, global political and economic conditions, commodity price behavior etc. In the short term, we have fewer variables and number one among them is sentiment. Allow me to quote an old (2002) study:
“Excess returns are contemporaneously positively correlated with shifts in sentiment. Moreover, the magnitude of bullish (bearish) changes in sentiment leads to downward (upward) revisions in volatility and higher (lower) future excess returns.”
If fear of loss is high, then prospective returns are high. Risk measurement will fail to distinguish between the “risk” in a long position of S&P 500 futures on December 24 and that same position on January 20 but the price was 10% lower and Vix had spiked up, from 15.74 to 27.59. Every money manager should look more favorably on that position in January than they did in December.
Calculating Energy Under Normal Conditions
What we need is a variable or index that tells us something about the risk of loss. To work, it must take into account all the key factors that drive the S&P in a one- to four-week horizon. They are:
- The level of fear;
- The time since we last suffered through trauma;
- Bond momentum.
To put it simply, if we have just undergone market trauma so fear is high and bonds have been rallying, then the risk of loss is very low. The further we get away from “the episode” and the lower fear (Vix) is, the worse our prospects are for making money in a long ES position. At that point, all we can hope for is a bond rally.
I honestly don’t think there is another important factor. (Please Contact me if you think of one.)