The last week has seen the S&P 500 index decline by 2.5% against our estimated 1.2% increase in its fair value over that period.
The fair value increase reflected the S&P’s:
positive correlation to the European stock indices which increased in price
negative correlation to the EUR/USD pair which decreased in price, and
positive correlation to USD/CAD which increased in price.
Such a divergence between the price movement and fair value movement would normally suggest the S&P 500 is a short term buy. Over the last 90 days, trading the index (using eg. a CFD or ETF) in accordance with these signals would have yielded an annualized gain of 25.3% with volatility of 12.5%.
Our fair value of the S&P 500 is about 8% above the current level. (However trading on the simple discrepancy between price and fair value would have generated negative returns over the last 90 days).
Whilst predictions of the future are hazardous, a possible scenario has European stock indices appreciating and EUR/USD depreciating as the ECB implements its euro 60 billion per month bond purchasing program. Based on the correlations, both of these would be positive for the S&P 500.
Amongst the many other drivers of the S&P 500, an oil price below $40 would be basically neutral for the index’s fair value and a further 10% drop in the DJ UBS Commodity Index would be marginally positive. The S&P 500 is also positively correlated to the gold price.
US GDP announcement
A provisional estimate of the Q4 2014 GDP (Annualised) is scheduled for release at 13:30 GMT today. The consensus estimate is 3.3% growth. We can find no statistical bias towards under or overshoot in past estimates.
Looking back over the US GDP announcement dates over the last three years (one each month), we find that volatility in the S&P 500 has actually been lower for these dates.
The average movement in the index was +0.07% on days the actual exceeded consensus and +0.27% on days the actual fell short of consensus. Our intuitive explanation for this apparent anomaly is that an overshoot increased investors’ perceived probability of monetary tightening and conversely. This appears to have outweighed the implications of the GDP result for the state of the economy.