The age-old question on every investor’s mind is if now is the right time to invest in the stock market. This question is typically a hot topic in a volatile market environment.
We often hear Wall Street analysts bemoan that a certain stock or index is extended.
Intuitively, we know what that means; usually, it is that the stock or the index has moved up or down, substantially, in a very short period. Ultimately anyone who classifies an investment as extended, to the upside, is simply trying to make the case not to chase returns in this kind of market environment.
Unfortunately, the word “extended” does not tell us all that much.
- Extended relative to what?
- How extended is it? A lot, a little, something in between?
How to Define Extended?
Let’s dig back into your memory, to that statistics class that you took in freshman or sophomore year of college, and you will find that there is a way to define or quantify extended.
It’s called the Z-score.
Do you have visions of that bell curve that you used to draw in your notebook popping into your head?
You should because that is exactly what I am talking about.
Here is a quick refresher:
The middle of the curve is the average of a population set and if we assume a normal distribution then,
- 68% of the data falls within one standard deviation of the mean.
- 95% of the data falls within two standard deviations of the mean.
- 7% of the data falls within three standard deviations of the mean.
Essentially, the Z-score gives us a sense of how far a data point is from the mean.
It is a measure of how many standard deviations above or below the average that data point lies.
Why should investors care?
Let’s relate this back to the stock market. Here is a two-year, daily chart of the S&P 500 with a 50-day moving average (top panel) and the 50-period Z-score (bottom panel).
We can see that in March 2020, the S&P 500 had a Z-score that approached -4. The index was nearly four standard deviations below the 50-day day moving average…arguably extended to the downside.
As a counter point, more recently on April 5, 2021 the Z-score was +2.69.
Does that reading of +2.69 qualify as extended? In your stats class it probably does. In the market, it may not:
Assumptions Must Be Made.
Unlike the normal distribution of the bell curve from class, where the average is fixed, in the market we are dealing with constant change.
In this case, the average is “moving”, a 50-day moving average. In an upward trending market, it may not be uncommon to see the Z-score reach levels above + 2 quite often. In fact, it has happened a few times since the March 2020 low.
In addition, you could change the length of the moving average and come out with a completely different result. The choice of time frame is always up to the investor.
Also, we must remember that stock prices are not normally distributed. The tails of the curve are “fat”. The outliers happen more often than a normal distribution might predict.
The Z Score is a great tool but relies on the subjective interpretation of the end investor. As with any other technical indictor, it should be used within the context of the prevailing market trend and, ideally, there should be confirmation from other uncorrelated datapoints.