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Probability Theory

Created:

12 May 2008

Written by:

Simon Thompson

Two weeks ago, I advised averaging into shorts on the FTSE 100 ('Get shorting', 2 May 2008) having previously outlined a weight of historical evidence suggesting the odds were heavily weighted against this countertrend rally being anything other than a bear market rally ('Histrionics', 11 April 2008).

I still firmly hold that view, even though the FTSE 100 breached the bear trend line at 6215, although that was specifically down to the momentum behind the mining sector, which has been the main driving force behind the recent index rise. However, as I pointed out last month, I believe the end game of this stock market countertrend rally comes when the rally in the miners has run its course and investors bank their huge profits ('Darkening clouds', 25 April 2008). And that could be far sooner than most commentators think as my research indicates that the odds of the market turning down in May are very strong indeed.

Over the past six weeks I have been carrying out some detailed analysis of stock market trends with some quite astonishing results. Firstly, let's consider what happens in the month of May when there have been pretty savage declines in share prices in the first four months of the year. Going back over the past eight decades, there have only been 11 years when the UK market fell in the range 5.3 per cent to 12.7 per cent between the start of January and the end of April. In no fewer than nine of these 11 years the market continued to fall in May, including six occasions when the UK stock market declined by more than 5 per cent during the month. The two exceptions were in 2000, when the FTSE All-Share index fell by 7.4 per cent in the first four months of the year, but managed to edge up 0.5 per cent during May, and in 1973 when the return in May was a meagre 0.1 per cent.

In other words, 80 years of history suggests that the odds are heavily stacked against the UK market making headway during the month of May if it has already sustained heavy falls during the preceding four months. And, with this thought in mind, it's worth noting that the FTSE All-Share index fell by 5.68 per cent between the start of January and the end of April, making it number 12 in the series.

If a warning light over this market rally is not already flashing, then it's worth considering another trend that dates back five decades. Namely, when prices move up too quickly in April, this is a very bad omen for the performance of the market in May. In fact, since 1958 there have been 15 occasions when the FTSE All-Share index has risen in the range 2.9 per cent to 8.4 per cent during the month of April. In all bar one of these years the stock market then fell in May. The exception to the rule was in 2003 when the UK market rose by 6.3 per cent in April and 4.1 per cent in May, albeit that this marked the beginning of the 2003-07 bull market. So with the FTSE All-Share index rising by 5.9 per cent in April this year, making it number 16 in the series, optimists will be hoping that 2008 will, like 2003, be the exception to the rule. The history books suggest otherwise.

All of this is of great interest this year because the FTSE All-Share index rallied from 3100 at the start of May to a high of 3198. That 3.16 per cent rise is at odds with both of these bearish trends, which each suggests that the market is more likely to fall, not rise in May.

Bulls should also be concerned that equity strategists at investment bank Morgan Stanley have recently called an end to the bear market rally in European equities. This is significant because these are the same strategists whose market timing indicators correctly called the top of the bull market last June; subsequently advised going long of the market on 13 August 2007 - before the Federal Reserve started cutting interest rates - which prompted a surge in global markets; and then correctly predicted in late January that we would see a bear market rally lasting two to six months taking prices 10-20 per cent higher.

Interestingly, Morgan Stanley believes that the March stock market lows probably marked the low point of valuations, but they foresee directionless and volatile trading until earnings trough - the bank's models factor in a 21 per cent fall in peak to trough earnings as margins revert back from peak levels to their historical averages. To put that into perspective, the consensus is still for 6 per cent growth in earnings this year for the MSCI Europe index. It's not difficult to envisage an earnings recession, either, as corporate profit margins are squeezed through significantly higher input costs including energy, wage inflation (which is unlikely to dampen until unemployment starts rising) and higher borrowing costs resulting from the sharp rise in wholesale money market rates.

So if Morgan Stanley's strategists are right and earnings expectations this year are so far wide of the mark, then it seems inevitable that the spring euphoria driving company valuations higher will have been misplaced. It's not only the history books that are flashing a red warning light over this rally.

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