The S&P 500 index has an 80% probability of ending 2009 between the low 970’s and 1150 to 1170.

Historical volatility for the past 3-months would suggest 971 to 1151 for 80% probability.  Implied volatility in the 3-month CBOE volatility index would suggest about 974 to about 1172.

. . . . . . . . . . . . .  DISCUSSION . . . . . . . . . . . . .

In our last article, we continued the discussion of price projection based on historical volatility.  We provided an historical example of quarterly projections from 12/31/2002 at 95% probability (2 standard deviations) based on 63 days (3 months) of daily historical volatility. Some of our readers have asked for a projection with a narrower range, so here is one based on 80% probability.

Multi-Year S&P 500 Price Probability Projection:

This chart projects forward from the beginning of each calendar quarter to the end of the quarter, based on the daily volatility of the prior calendar quarter.  Each cone delimits the area on the price chart that is likely to contain 80% of the closing prices. That still leaves roughly 10% that might close outside of the cone on either side, but prices are more likely to be inside the cone than outside, so long as the level of volatility in prices remains about the same as in the prior quarter.

The chart also shows the 63-day (3-month) price channel for comparison.

click images to enlarge

Implied Volatility in S&P 500 Options:

While volatility could pop up at any time, it has a recent general pattern of decline.  That makes a bet on same to lower volatility not unreasonable (in the absence of new shocking news).  This long-term VIX chart shows the pattern of change in one-month volatility expectations for the S&P 500 over 20 years.

Looking more closely at the daily VIX for the past 3 months, the pattern of volatility decline is clear. Declining volatility would tend to make price probability projections based on past volatility more reliable.

The quarterly price probability projections from 2002 through 2009 are for 3-month forward periods.

For a better fit than the VIX which looks forward 30 days, let’s look at the less noted CBOE 3-Month Volatility Index which looks forward 3-months.  That index is also declining, supporting the current reliability of the price probability projections.

While same or lower volatility supports the price probability range, it does not support direction.

A prior article provides discussion of using options implied volatility to project future prices.

Trend Direction for S&P 500:

For directional clues, we need to look to trend indicators, such as moving averages.  Looking at longer-term trends, the cross-over pattern of the 26-week and 52-week simple moving average of the S&P index is bullish.

Looking shorter-term, the 1-year daily chart of the S&P 500 shows that a series of simple moving averages of different lengths are stacked in a bullish pattern (price higher than the shortest average, and each moving average higher than the successively longer average).

Price Projection Summary:

Taken together, we think these charts reasonably indicate a year-end 80% probability closing price range between 1150-1170 and the low 970’s (from the Oct 13 close of 1073; from up 7% to 9% through down 9+%).

The quieting volatility increases our confidence (absent new shocks) in the range.  The longer-term and shorter-term trends suggest a bias toward the upper half of the probability range.

That said, we are not at all comfortable with the general economy in the U.S. and cannot make a fundamental argument for the price levels of the S&P 500 index.  However, we do not wish to argue with the market.  Because shocks and sudden reversals are always possible, we have persistent trailing stops on all of our listed positions.

Questionable Fundamentals:

All the U.S. has done is kick the problems of 2008 down the road by transferring private debt to public debt.  The federal government seems to be using the cover of bailout to expand the scope of government and its cost beyond the levels required to delay or solve the economic problems.  The federal, state and local tax burden is about to increase substantially with negative impact on business activity.  The federal government has taken certain actions and expressed certain views that are hostile to capital.  The quality of bank assets in the event of rising interest rates is in question, and the scope of loan defaults that lie ahead is uncertain to negative.

There are some good things happening elsewhere, such as Australia raising its central bank rates in response to favorable economics. China seems to be growing well (although the government there has some concerns about the quality of that growth), but they have the financial reserves to continue stimulus if necessary.

Basically, trying to fathom all the different economic reports around the world and to absorb all the divergent opinions is a bit like drinking from a fire hose.

We do buy into the argument of a secular shift of economic power and growth from the West to Asia, and are shifting assets accordingly.

One nice thing about charts is that they tend to distill all the myriad data and opinions into a single thing — the price.  The price and price action may not be as forward looking as opinions, but the price is what makes or breaks your portfolio.  We don’t believe in arguing with the market when it is moving as it is.

Conclusion:

Price probability projections based on historical volatility (as well as on implied volatility for securities with high option volume) are helpful in understanding and managing risk and opportunity.

We see an 80% chance of the S&P 500 closing 2009 at between roughly 970 and 1170.  We don’t see too much reason for melt-up beyond 1170, but can imagine reasons for melt-down below 970.  Use persistent trailing stop loss orders to limit risk.

. . . . . . . . . .

Securities directly related to this projection: These securities track the S&P 500 — SPY and IVV.

Securities closely related to this projection: These securities are broad U.S. index funds with an extremely high correlation of price change with the S&P 500, making S&P 500 percentage price changes potentially highly relevant to them as well — IWV (Russell 3000) , IYY (Dow Jones Total U.S. Market), ISI (S&P 1500) , TMV (DJ Wilshire Total Market), VTI (MSCI Prime U.S. Market), RSP (S&P 500 Equal Weight).

Disclosure: We own SPY and VTI in some managed accounts, and may own some of the others from time-to-time.

Richard Shaw
QVM Group LLC

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