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3 Sigma Should Be Rare 

My team and I manage wealth for C-Suite executives. While we utilize both fundamental and technical analysis, we absolutely have a bias towards technical analysis. Arguably the biggest reason we use technical analysis in our work is the simple realization that volatility begets volatility. 

If you understand statistics, you know that “standard deviation” is simply the amount of variation from the mean. You might also remember that 97% of normally distributed data falls within three standard deviations. In plain English, this means that it should be very rare to see data that falls outside three standard deviations. 

This is not what we see in the financial markets. I offer the chart below as simple proof. 

This chart is constructed using the calculations from Greg Morris’ book Investing With The Trend. If you have not read that book, I highly recommend it – just know that it’s a commitment to get through it. 

In his book, Greg documents how he calculates the average daily return and standard deviation for the S&P 500 over a 5-year lookback period. According to his work, the daily mean was 0.07% and the standard deviation was 0.71 percent. Once we have the standard deviation, we can determine that 3 sigma (standard deviation) up would be a daily return of 2.21% and 3 sigma down would be a daily return of negative 2.06%. In the bottom pane, 3 sigma up is denoted by the green dashed line and 3 sigma down is denoted with the red dashed line.  

Remember, a 3 sigma day should be rare. Yet, when we look at the data, we can see that they are far more common than they should be. We can also see that they are frequently clustered together.  

More Decliners 

If you are a regular reader of this newsletter, you likely know that the Advance-Decline line can be a key clue as to the underlying health of the broader market. Yes, the S&P 500 can go up. But if you understand how that index is calculated, you know that a very small number of stocks can drive that index higher all the while the majority are going down. 

As a result, we like to look at the Russell 2000 and the Rusell 3000. The second chart today is showing the Russell 2000 along with its Advance-Decline line in the bottom pane. 

First, the good news. While Friday opened lower, take a look at the red circle to see Friday’s candle. It is white. So, the market may have opened lower, but the bulls stepped in and helped the Russell 2000 rally and close basically unchanged from Thursday. 

Now, the bad news. The Advance Decline line moved lower. That is not bullish. 

Buy Evidence-Based Investing Now on Amazon.com  

“But It’s November.” 

If you know your stock market history, you know that November is historically the best month for stocks in the year. Our third chart is a Seasonality Chart showing the average monthly performance for the Russell 2000 since 2001. November is clearly the winner. 

But notice that blue diamond at the bottom, just above the word “November”. That blue diamond represents this November.  

Just because November is historically strong, does not mean that this November will be strong.  

Trend Change? 

The final chart for today is TLT, the iShares 20+ Year Treasury Bond ETF. Here I am showing a weekly chart so we can look at the big picture. 

In common investment theory, bonds are considered to be “safer” than stocks. I discuss how misguided this theory is in my book Evidence-Based Investing. A simple glance at this chart disproves any notion that bonds are “safe”. There’s no such thing as a “safe” investment; everything carries some degree of risk. If you are actively managing your investment portfolio, your number one job is to manage risk. See my book for a further discussion of the topic. 

If you were to look at the daily chart for TLT, you would see that Friday’s price action was decisively negative. However, I would argue that the price action was simply testing some short-term support. 

Now look at the long-term chart shown below. While keeping in mind that all trend lines are subjective, it looks to me that the recent price action is returning to test the long-term down-trendline. Typically, when multiple timeframes intersect, we should take note. If these levels hold, perhaps we are seeing a trend change? If TLT moves through $92.44, I will have more confidence in that thesis. 

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Shared content and posted charts are intended to be used for informational and educational purposes only. CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. CMT Association does not accept liability for any financial loss or damage our audience may incur.

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