Tuesday, February 24, 2009

New Lows, and Psychology With the Major Indices

Well, I haven't had to do one of these posts in a while. On Monday, the U.S. stock market plunged to fresh lows for this bear market, to the point that all three leading U.S. indices finished the day at their lowest marks since 1997. This now means that we have moved lower than the lowest that the market ever got during the entire bursting of the dot-com bubble, and the aftermath, including a mini-recession, following the terrorist attacks in September 2001. At this point, the S&P 500 index of the 500 largest stocks in the market has now dropped 52.5% from its highs in October 2007 on a closing bases, once again confirming this to be the worst bear market since the Great Depression, and if we manage to sink just another two percent or so on the S&P, that will make this officially the worst slide in the broad index since the bear that began with Black Monday and the crash of 1929.

With the market's latest slide to fresh 12-year lows, it begs the question once again: how much longer can this bear market realistically last, and how much further can it drop?

Let's go in reverse order, starting with the magnitude question. Remember the chart I have posted here on a few occasions over the past several months:

S&P Composite Price Index Bull and Bear Markets 1914-2008

Market TopIndex High% IncreaseMarket BottomIndex Bottom% Decrease
10/9/2007 1565.15 101.5% 12/203/2009 743.33 -52.5%
03/24/2000 1527.46 59.6% 10/9/2002 776.76 -49.2%
07/17/1998 1190.58 304.3% 10/08/1998 957.28 -19.6%
07/16/1990 369.78 67.1% 10/17/1990 294.51 -20.4%
08/25/1987 337.89 233.1% 12/04/1987 221.24 -34.5%
11/28/1980 140.52 61.7% 08/12/1982 101.44 -27.8%
09/21/1976 107.83 73.1% 03/06/1978 86.90 -19.4%
01/05/1973 119.87 73.0% 10/03/1974 62.28 -48.0%
11/29/1968 108.37 48.0% 05/26/1970 69.29 -36.1%
02/09/1966 94.06 79.8% 10/07/1966 73.20 -22.2%
12/12/1961 72.64 86.4% 06/26/1962 52.32 -28.0%
08/02/1956 49.75 267.2% 10/22/1957 38.98 -21.6%
05/29/1946 19.25 157.7% 06/13/1949 13.55 -29.6%
11/09/1938 13.79 62.2% 04/28/1942 7.47 -45.8%
03/10/1937 18.68 131.8% 03/31/1938 8.50 -54.5%
07/18/1933 12.20 120.6% 03/14/1935 8.06 -33.9%
09/07/1932 9.31 111.1% 02/27/1933 5.53 -40.6%
09/07/1929 31.86 408.9% 07/08/1932 4.41 -86.2%
07/16/1919 9.64 60.7% 08/24/1921 6.26 -35.1%
11/20/1916 10.55 59.1% 12/19/1917 6.00 -43.1%

Having updated the top line of this chart for this week's unsavory market action, you can see how this has now clearly eclipsed anything we've seen since the late 1930s in terms of the drop from peak to trough in the S&P 500 index. Unfortunately, this leaves us in a bit of uncharted waters as far as predicting how much more weakness there could be from here. In 1937-38, after a 131% runup from the 1935 lows, the broad market tumbled 54.5%, just a shade above what we have experienced so far on Wall Street. And of course, there was the original crash that is commonly thought to have begun the Great Depression, where stocks ran up a sick 408% from 1921 through 1929, only to plunge by an inconceivable 86.2% over the following three years.

For starters, let's just think the unthinkable for a minute here. What if the S&P or the Dow dropped 86.2% again from the highs, top-to-bottom, this time around? That would leave the S&P 500 index at 215.99. And the Dow, which peaked at just over 14,000 in October 2007, would be left at right around 1,940. Those numbers are so ugly to think of, that I'm simply not going to. The Great Depression occurred after a confluence of a number of events, much of which involved our government more or less turning a blind eye to the nation's troubles and simultaneously increasing protectionism at a time when our economy was far too fragile to handle such moves. Although a deaf, dumb and blind man could easily call into question the quality of the governmental response to the crisis this time around, the fact remains that we are far from turning a blind eye to the issues. And with globalization already a reality, a significant increase in protectionism like we saw in the 20s and 30s is unlikely to occur at this point or perhaps ever again for this country. So I believe that a drop of 86% like we saw in the Great Depression is not called for given what we know so far about the current situation. Things are terrible for sure, but we've already dropped 52.5% at this point, so the badness has been factored in to a historically very significant degree already.

Looking at the chart, as I have pointed out before, the best predictor we have of the magnitude of the drop from the highs seems to be the magnitude of the runup leading up to that market top. As I wrote about last year, leading up to this 86.2% drop in the S&P from 1929-1932, we had an unprecedented 408.9% surge from the lows of the previous cycle in 1921. Leading up to the 54.5% decline in the S&P from 1937-38 was a 131.8% spike from March 1935 to March 1937. From August 1982 through August 1987, the S&P 500 jumped over 233%, but two months later was the single worst day in the history of the market in percentage terms as the S&P lost around 20% of its value in just one day. Although this pattern is far from perfect throughout the years, generally speaking it is fair to say that the smaller trough-to-peak runups have led to smaller peak-to-trough selloffs following those runups.

Using these figures as a guide, the run from the October 2002 bottom for the S&P to the October 2007 top was 101.5%. This is a big spike in historical terms, but in looking at the chart it only represents the 10th-largest trough-to-peak gain for the S&P in the past 100 years. This seems to suggest that, with stocks now showing the third-worst bear market drop in history, it is unlikely that we see a huge further drop from current levels. Now of course a whole lot more goes into this equation than just how low the S&P had gotten in 2002 and how high in 2007, but as I said above there is not a lot of evidence to suggest that we are going to see a drop of anything even remotely close to the magnitude of the Great Depression here. At this point I would be a bit surprised to see us make fresh 12-year lows on the major indices for exactly one day and then not drop any further, but I am thinking maybe another 5-10% or so from here would fit in very nicely on the chart above as the bear market lows for this cycle. Let's all hope I am right about that.

Now, let's move on to the question of the likely length of this bear market, which I find to be the more interesting of the two aspects to consider. I've had this theory for a long time, and yet it's not something I have really ever heard or read anywhere else that I can recall. It's a theory relating to the technical aspects of investing, and the psychological underpinnings of major indices like the Dow Jones Industrials Average which are known, followed and focused on by millions of investors not just in the United States but all around the world. Using this theory led me to make a seemingly incongruous prediction around the turn of the millennium ten years ago, but the more crap we go through with this market and with the DJIA, the more I find myself turning back to this theory and thinking there might really be something to it.

The theory I am talking about posits that the DJIA, easily the single most followed and known major market index on the planet, has major problems whenever it first reaches and surpassed major psychological milestone levels. Now, with the Dow only being around for about 110 years, and with there not being many major psychological levels to pass during that time, there are admittedly not a lot of data points to work from with the Dow, but take a look at this, a chart showing the history of the Dow Jones Industrials Average since 1900:

As you can see, the DJIA crossed the 100 mark for the first time in late 1916. I view this as the first of the psychologically important breakthroughs for the world's most widely-followed index, the first move into triple digits. Although the market was in a sustained uptrend at that time, you will note that the index bounced right off of the triple digit mark as soon as it touched there in 1916, and it took another three years or so to get back to retest that 100 level. The thing I tend to focus on, though, is not how long it took the market to plow consistently through this important psychological point, but rather how long it was until 100 was passed on the upside for the last time, not the next time. So, in other words, the Dow first hit 100 in 1916. I want to know how long did it take before the Dow moved back above the key 100 for the last time, i.e., for good? And the answer? In late 1942, with World War II looming, the Dow bottomed at 92 and change, before rallying furiously to over 200 by shortly after the end of the war and the beginning of what we today refer to as the Baby Boom. So that is 26 years from the first time the Dow touched 100, to the very last time it touched 100 and left that level in the dust, never to be thought of again. In my view it took 26 years for the Dow to officially "break through" the key triple-digit level from the very beginning to the very end. 26 years. That is an entire generation of investors dealing with the reality of the 100 level on the Dow.

Now let's move on to the next key psychological barrier -- quadruple digits. The Dow first touched 1000 on an intraday basis in early 1966. In fact, the DJIA four times crossed the 1000 mark in the mid 60s, on all four occasions failing to climb above 1001 before falling and closing below the key 4-digit mark. In fact, take a look at that chart up there at the period starting in 1966 when the major index first touched 100, and you will see at least five separate tops where the market rallied back to right around the 4-digit mark before failing and dropping back below as investors struggled to get their minds comfortable with the DJIA being at a 4-digit number. From the chart I would even go so far as to say that this stands out as the most prolonged period of plateau in the Dow in the entire history of the index. After a big drop during the 1981-82 recession, the Dow finally crossed the 1000 level on the upside for the last time in late 1982. So how long was it from the first touch of this key level on the Dow -- early 1966 -- to the time that the Dow flew past 1000 for the last time, finally disposing of the psychological barrier that is a four-digit Dow? 16 years.

So, it took 26 years for the investing public to get psychologically comfortable with the DJIA in three digits, and it took another 16 years to get comfortable with four digits. So what's the next big psychological milestone for the Dow? Yep -- 10,000.

The Dow first crossed the 10,000 mark on March 12, 1999, in what turned out to be the absolute height of the dot-com bubble. I remember it like it was yesterday. Me and a bunch of fellow clowns decided to skip our classes in law school that day and just sit home, get hammered and watch as the Dow first crossed this key level, at the time thought to be indicative of just how far the U.S. had come, and how we had enabled technology to lift us to new heights, financially speaking. As we saw with the first touch of 100 and of 1000, there was some immediate pullback from that point, but unlike what we saw with 100 and 1000, the market took it pretty well in stride right away this time, consistently closing above 10,000 within a month or so of first touch. Soon after, however, the market topped as the internet bubble burst in a big way, and the market spent the better part of 2000-2001 dillydallying right above 10k before finally dropping below it in the wake of the 2001 terror attacks which closed Wall Street down for a week. The Dow then proceeded to drop as low as 7286 during the recession of 2001-2002, before resuming a huge rally that carried the world's most widely-followed index to a stunning high of just over 14,000 in October 2007, actually making me rethink my psychological barrier theory as the index threatened to leave 10,000 in the dust after just a few short years.

But never fear, psychology always seems to win out in the end, and here we are with the Dow languishing once again in the low 7000s, nowhere near 10k and certainly not having left 10k in the dust as I had been hoping just a couple of years ago. Now to be sure, I'm not at all trying to say that the only reason the market is down now is psychology related to the Dow 10,000 level. That would be preposterous and would deny the very real financial and economic problems impacting our country right now. But that's the same story with the Dow's stallout at the 100 level -- the Great Depression hit, the worst unemployment and economic times in our country's history -- and again with the problems the Dow had with the 1000 level, which saw the oil crisis and the stagflation of the 1970s. But, I can't help but notice it nonetheless. I mean, can you deny the parallels?

So how much longer could this bear market last? Well, it took the Dow 26 years from the first time it crossed 100 to the last time. It took 16 years from the first time it crossed 1000 to the last time. And now we crossed 10,000 for the first time in early 1999. Let's just take an average of the first two psychological barriers -- 21 years. That would mean it would be 2020 before the Dow is finally finished with 10,000 for the last and final time. This doesn't mean that the market couldn't have several powerful rallies and make investors billions of dollars between now and then. It just means that, if the theory holds true, we could be dealing with Dow 10,000 plus or minus, say, 30%, for still another decade-plus, and it would not be out of the norm from a historical perspective.

And while Dow 10k in 2020 probably sounds vomitous to many of you out there (and it should), you have to note that at least that would mark a 40% up move from here.

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Blogger Mike G said...

So you had to spill all that ink to reach what conclusion exactly? That we could be in for a lot more of the same? I've got to agree with the other guy, stick to poker.

4:58 AM  
Blogger Chad C said...

MikeG I suggest you read blogs you like mabe?

PS get aids

10:55 PM  
Blogger Ignatious said...

screw what mike said. i've been coming here specifically for posts like this. and even sending em off to friends. poker pales.

my humble two cents.

11:03 PM  

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