Wednesday, June 5, 2013

2013.06.03 DJIA Cycle Model and Z-score

In case the reader has not followed the progress of the DJIA cycle model, I want to emphasize that of the four cycle models I present here, DJIA, Gold, Silver, and Oil, this is the least predictive model. I believe the reason is that the model looks at a conglomeration of historical business cycles since 1896 as reflected in the Dow Jones Industrial Average. The US Federal Reserve has been buying assets and expanding its balance sheet to the point where the process is now in uncharted territory. This has introduced an "error" in the model parameter estimates because the current level of asset buys dwarfs the last time the US Federal Reserve engaged in asset buying during and shortly after WWII. This error has not been transmitted to the other three models. At least not for now.

The z-score measures how much the prediction deviates from the actual price on a historical basis. The current Z-score shows that the model is deviating 2 sigmas from the mean, which is the largest deviation since 1929. All things being equal, the prediction would be for strong downward pressure on the Dow until early to mid 2014.