History Shows this Market Has Even More Upside

By Salil Mehta, statistician

NEW YORK ( TheStreet) -- On July 22, the S&P 500 (e.g., the SPY ETF return as a proxy) closed at another record high, its 47th of the year.

We may find ourselves in the familiar territory of asking where the markets will go now, just as we may have asked after the 46 record closes that preceded it. Will we extend to another record close? Or will we retrench?

We can look for clues in similar periods, when investors and policy officials were asking similar questions.

The main reference for the government and central bankers is the period leading up to the Great Depression. That secular bull market ended in August 1929, just before most of the effects of the Great Depression, and it took 25 years for the market to recover, even longer in Europe, with World War II intervening.

While that duration of the global market recovery was lengthier versus today, the pronouncement of market choppiness and unsettled investor sentiment is exactly the same.

During that time, bouts of volatility were commonplace in multi-year increments, similar to what we have in recent years. And each bout in volatility led to a lower high and a lower low. And it continued over and over. Until it didn't.

Doesn't this sound similar to what we've had in this market recovery? Even more similar was the investor sentiment that reaching new highs in the financial markets was to be treated with even greater suspicion, as there was no global precedent for a faster recovery.

Let's look also at other periods of inflection in the S&P 500 history to gauge where we are.

These periods are not necessarily bull market peaks, but simply record-creating rallies where the underlying market sentiment was similar to what we have today, for example, 1964 or 1996.

We can examine a broad set of market statistics for these market periods in the history of the S&P 500 and compare data for about nearly a year's worth of trading data leading up to the event shown in the following table.

Look at the S&P 500 total return measure calculated with a continuous 0.0073% daily yield to the price changes. I would be happy to provide the underlying data set.

We'll look at the event from 17 years, or December 5, 1996, when then Federal Reserve Chairman Alan Greenspan commented on a similar quandary concerning rising asset prices. He used what became the (in)famous phrase "irrational exuberance" when questioning the source of escalating asset prices.

I am in touch with economist and author, Professor Robert J. Shiller, who as recently as this past weekend, looked to contrast any current bubbles to the period in 1996 that he captured in his best-selling book, Irrational Exuberance.

So how do the recent record streaks in U.S. equity markets contrast with those in 1996? We find that in some respects the current market's record-setting highs appear more jumpy and less expected, as one might deduce from the still unknown conclusion of an unprecedented monetary-engineered activity.

I have a noteworthy perspective on this, having led the analytics team for the $700 billion TARP program at the Department of the Treasury.

The current record-close streaks lasted 233 trading days (nearly a year in length), before ending in August 2012. So let's examine the two 233-trading day periods prior to both events in the illustration below.

In blue we have the stretch leading up to Alan Greenspan's "irrational exuberance" comments. In red we have the stretch leading up to a recent record close in July 2013.

We notice, for example, that 10 days prior to Alan Greenspan's comments, the S&P closed at a sixth straight record.

On the surface not much looks different between the two time periods. After all, they both have the same peak streak of six straight record closes.

But a more relevant econometric measure to look at for both periods is the proportion of trading days that were record closes. This figure in 1996 was just 16%, while this year it is 24%. The proportions are relatively equivalent to what is shown on the earlier total return table.

And the point here is that we are clearly now afforded more opportunities to easily achieve these record-closing streaks.

An important missing component to this analysis, however -- one that helps us to understand the difference between the recent market performance and that of 1996's "irrational exuberance" performance -- is the variation in streak performance during the periods.

We will define variation here as the standard deviation, which is a common risk measure in finance. During 1996, this variation was slightly less, implying that record trading days that initiated any streak were steadier and more of a given.

Despite implied volatility indicators being similar both now and then, recent market participants are this time more wary of a pullback, speculating that the liquidity-driven rally might support a market retrenchment.

We have then calculated statistical ratios of the portion of record days in relation to the variation in streaks associated with that time event. This assists in measuring the performance in record streaks, adjusted for estimation risk, quantitatively.

And the statistical ratio shows higher values now (21%) than in 1996 (17%). So this adjusted indicator is registering a high degree of upward bias in the markets, even adjusting for variational risk, versus the "irrational exuberance" period.

So things indeed are much different this time.

The lessons we learn from contrasting this recent market environment to both the Great Depression and the "Irrational Exuberance" period, is that with greater policy maker's attention to the markets, a sustained low period of volatility does not return until much later after the inflection period is carried out.

Currently, we are in a bottoming phase of market volatility. This phase has already occurred in the fixed-income markets, other global equity markets, commodities and in specific industry sectors of the U.S.

By the time rates rise, we can see a heightened volatility regime return once more. The author has performed rigorous statistical analysis on when rates will firm and shows that this is a one-in-five probability for 2015.

And in any event, higher volatility doesn't mean that equity prices can eventually rise to new levels. In fact, as an epilogue to the 1996 event, we note that roughly two quarters after Greenspan's irrational exuberance comments, the markets had a substantial correction, but then proceeded to form the much higher technology bubble peak that defined the times.

The market recovery from the Great Depression took quite a while longer, as noted before, as the central bank had less political comfort in the fewer accommodative tools they had available then.

There is no reason to assume that we could not more quickly get past this current inflection period and resume a more volatile and eventually upward path.

Written by Salil Mehta, creator of the Statistical Ideas blog.

At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Salil Mehta is a statistician and econometrician. He has 16 years' experience, including a dozen years on Wall Street doing proprietary trading and economic research for firms such as Salomon/Citigroup and Morgan Stanley.

He also served for two years as the director of analytics, in the U.S. Department of the Treasury for the $700 billion TARP program. He is also former director of the policy, research and analysis department of the Pension Benefit Guaranty Corp.

He completed a graduate degree in mathematical statistics from Harvard, and is currently an adjunct faculty member at Georgetown. He is an independent consultant for public and private sector organization, has completed writing a statistics book, and is the creator of the Statistical Ideas blog.

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