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The stock market, sitting as it is on a year-to-date gain of nearly 9%, stands a two-out-of-three chance of being even higher at year’s end.
Not bad, you no doubt will agree.
But what you probably don’t realize is that those odds have nothing to do with how strong the market has been so far this year. The odds of a positive second half of the year would be the same even if the market were today posting a year-to-date loss of 9% as opposed to a gain.
This concept is hard for many of us to accept. Doesn’t the market exhibit trends?
In retrospect, of course, it certainly appears as though there are distinct trends. But much of what we think are trends are in fact nothing more than the stories we tell ourselves to make sense of what is otherwise a lot of randomness.
The proof of this is in the eating. Consider the percentage of time the Dow Jones Industrial DJIA, +0.07% rises in the second half of the year. Since its creation in 1896, it has done so 66.7% of the time, on average — or two out of every three years. In just those years in which the Dow rose in the first half, this percentage is only slightly higher, at 71.6%. (See accompanying chart.)
According to my PC’s statistical software, this difference between 66.7% and 71.6% is not significant at the 95% confidence level that statisticians often use when determining if a pattern is genuine. The most likely explanation, therefore, is that the odds of a rising market in the second half of year are no higher in years when the market rose in the first half of the year.
To be sure, these statistics don’t differentiate between years like this one in which there has been a great first half and those in which the first-half gain is tiny. But there also is no correlation between the magnitude of the market’s first half’s gain or loss and its performance in the second.
Indeed, I could find no way of slicing and dicing the data that came even close to satisfying traditional tests of statistical significance.
This finding is something we should actually celebrate, according to Lawrence G. Tint, chairman of Quantal International, a firm that conducts risk modeling for institutional investors. In an interview, he said that the market would be “subject to unnecessary and unhealthy turmoil” if the market’s return in one period were correlated with its return in the previous period. “We can be comforted by the fact that reasonably efficient markets always base their level on anticipated future returns, and do not include history in the calculation,” he added.
Note carefully that I am not saying the market won’t rise between now and the end of this year. The odds of such a rise are two out of three, after all.
My point is, simply, that those odds have nothing to do with the market’s gain so far this year. As you place your second-half bets, you need to ignore the past and focus instead on what you think is going to happen that is not already reflected in stock prices.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email email@example.com.