Many have wondered why the 10-year cycle
peak in late September/early October didn't produce a more meaningful
correction in the broad market. Instead, the 10-year cycle peak produced only
a marginal six percent pullback in the S&P 500 Index (SPX) instead of the
much deeper one usually associated with the 10-year peak.
A look at the past reveals why: the
first full year following a crash low has never produced a sizable correction
in the stock market. That historical truism certainly proved itself out in
2009. But what of the second year after a crash? What can we expect in the
coming year based on market history? We'll be taking up this question in the
commentary that follows.
The two most persistent traits that
investors displayed in 2009 were either the avoidance of the stock market
altogether by remaining in the safety of cash or else to look for
opportunities to sell short each time the market took so much as a breather.
Both of these tendencies were direct consequences of the historic credit
crisis of 2008. It has long been observed that retail investors typically shy
away from equities for at least the first two years following a major bear
market or stock market crash. The painful memories take time to heal and
leave deep and abiding scars.
Even for those stalwarts who stay the
course and continue trading and investing, a market crash creates a tendency
toward conservatism. Traders tighten up protective stops on all their trades,
avoid over-trading, refuse to buy large positions in any one stock and make a
serious effort at avoiding the mistakes that were made during the heady days
of the forgiving bull market. Indeed, the reversion to conservatism and
self-examination among market participants is one of the redeeming qualities
of a market crash. Bear markets are purgative in that they cleanse the system
of lavish excesses and restore a sense of propriety to the market by and
large.
For those investors who respond to the
destruction wrought by a crash by refusing to participate, the resulting
effect is equally beneficial to the overall soundness of the market. These
non-participants, who comprise the great majority of all potential retail
investors, will spend the next year building cash reserves and restoring
their personal balance sheets. While this won't necessarily be of any benefit
to the stock market, nor to those who make their living in the brokerage or
advisory business, it will act as a reserve - or liquidity bank if you will -
for the future. For at some point the market will need this liquidity and by
the time those reserves are needed, the painful memories of the previous bear
market will have dissolved from the public's collective memory. As their
confidence grows they will become more enticed by the lure of the potential returns
of stocks vis-à-vis the low-yielding safety of the bond market.
Returning to our original observation
concerning market behavior in the 1-2 years following a crash, let's examine
some chart examples of the past few bear markets. Perhaps the single best
example and the one that most closely correlates to our time is the crash of
1973-74. This particular bear market was a function of the Kress 40-year
cycle, which bottomed in October 1974. It produced a painful and persistent
decline in the S&P 500 for the better part of two years, as well as an
economic recession. At the time this happened it was the worst bear market
stocks had suffered since the Great Depression. By the time it ended the SPX
had lost some 45% of its value. As you can well imagine (and some of you may
actually remember it), the feeling at the bottom in October '74 was one of
unmitigated doom and gloom - a feeling that persisted in the public's mind
well beyond 1974.
The market was anything but forlorn in
the two years following this bear market. In the year 1975 the stock market
rallied vigorously and with relatively mild corrections along the way. The
Dow Jones Industrial Average (DJIA) rallied 100 percent in '75, a record
performance following a bear market and one that stands to this day. The
market continued its recovery into 1976, and although its '76 performance
wasn't anywhere near as stellar as the one in '75 it remains immune to major
corrections and kept the recovery going for two full years following the bear
market low in 1974.
Of course the market cycles which
comprised the 1973-74 bear market were considerably different than the cycles
underlying the 2007-08 bear market. Yet the market dynamics between the two
eras are so remarkably similar that the inference can still be drawn that
ours is a situation analogous to the 1975-76 recovery.
Notice in the above chart of the Dow
that the 1976 follow-up to the explosive 1975 rally was much more volatile
and less dynamic, yet it was still a positive year overall for the Dow. The
possibility exists that 2010 could end up being a positive year overall in
spite of the 4-year cycle bottoming later this year. The inference that can
definitely be made is that the coming year will almost certainly show more
bumpiness than 2009 and less dynamic market action.
If 1976 holds any clues for how 2010
will play out then we can expect more range-bound behavior from the major
indices. This means stock selection will become more important as the sectors
showing only the best relative strength, forward momentum and earnings growth
should be favored over weaker sectors. The coming year is likely to reward
good stock selection as opposed to the "buy with both hands"
strategy that played out so well in 2009. Market timing will also be more
critical in 2010 as opposed to last year since there are two major cycle
bottoms scheduled this year: one in the first quarter of the year and one
around late September/early October (namely the 4-year cycle).
The next example in our survey of bear
markets is the bear market of 1981-82. From the depths of this bear was
spawned an apocalyptic sentiment made infamous by several high-profile movies
with Armageddon type themes in the early '80s. While the '81-'82 bear market
wasn't as severe as the previous one of '73-74, it was strong enough to exert
a profound influence on investor psychology and left the retail investment
crowd with a revulsion toward equities for the next 2-3 years. It also
launched the powerful '80s bull market, which didn't meet its apogee until
the end of the decade.
Let's turn our attention specifically to
the 1-2 years following the '81-'82 bear market. As you can see in the following
chart example, the first full year following the bear market low saw no major
correction in the SPX. Even 1984, which saw considerably more volatility than
'83 due to the bottoming 10-year and 30-year cycles, wasn't as bad a year as
it probably should have been.
This is significant for several reasons.
Consider that 1984 by all indications should have been a bearish year, yet it
wasn't that bad for stocks in the overall scheme in spite of the fact that a
major long-term Kress cycle was bottoming. The reason for this was because
the public was still scared to the point of non-participation and the
lingering abhorrence to equities following the bear market from two years
prior was still a major factor. This can't be is emphasized enough. As
ephemeral as crowd psychology can be, when the retail investor is paralyzed
with fear and revulsion toward stocks, the market enjoys a strong support
regardless of the cycles that may be leaning against stocks as long as tight
money conditions aren't prevalent. At extremes, negative crowd psychology is
strong enough to contend even with the cyclical forces of the stock market up
to a point, and assuming money isn't inordinately tight.
The next bear market in our survey was
one of the shortest in history. I'm referring of course to the stock market
crash of October 1987. Its after-effects in the public mind were profound to
say the least. The SPX launched a recovery rally early in 1988 and continued
its recovery into 1989 with nary a correction along the way. The '88-'89
period is an example of a 2-year period following a bear market with nothing
bigger than an eight percent correction along the way.
Next we come to the bear market of 1990.
The year 1990 was a painful one for stock market investors as it heralded a
bear market and a serious crisis for savings and loan institutions. The year
1990 was the single worst year of the S&L crisis and saw the failure of
more than 100 small banks. The SPX declined sharply between July and October,
when the 24-year cycle bottomed. Following this important cycle bottom, the
stock market regrouped and began a new bull market that lasted until the
30-year cycle peaked in late 1999. For our purposes we will only observe that
the two years following the October '90 bottom saw the SPX launch a recovery
that saw only mild periodic corrections along the way.
Next we come to the summer 1998 market
crash and mini bear market. According to history we should have seen a 2-year
recovery off the September '98 low. Instead, the turn of the century
witnessed the commencement of the 2000-2002 "Tech Wreck" which saw
the NASDAQ bubble burst. Internet stocks were particularly hard hit in the
2000-2002 period. The more conservative Dow 30 Industrial stocks fared
considerably better than the tech stocks in 2000, which was the second year
of the post-'98 crash period, however. The year 2000 proved to be more or
less a lateral trading range in the Dow, which prepared the way for the next
crash that was to follow in 2001-2002. The year 2000 was one of the rare
exceptions to the 2-year recovery rule that normally follows a crash. It
failed to extend the rally of 1999 because by '99 the Internet bubble had
peaked, the Fed had begun tightening the money supply and conditions were
simply ripe for a bear market to come one year earlier than normal.
Going back 100 years, the only other exception
to the 2-year recovery rule we can find occurred in 1922-23 following the
stock market crash of 1921. The market rallied the year following the '21
crash but didn't follow through in the second year, as per the norm. In fact
1923 was similar to the year 2000 in that it saw the Dow undergo a volatile
trading range, closing for the year at roughly break-even. Even when the
second year after a crash fails to show a clear upward bias, as in 1923 and
2000, the market still at least shows a relatively neutral bias and has
rarely if ever experienced a decisive downward trend in the second post-crash
year.
This brings us to the present. With the
most recent bear market almost one year behind us, we've seen an extended
market recovery since March 2009 with nothing worse than a six percent
correction along the way. Our historical survey tells us to expect more
headwinds in 2010 due not only to the above mentioned cyclical factors but
also to the fact that the market will be running into more overhead resistance.
Volatility is almost sure to become a bigger factor in 2010 than it was in
2009 and history shows that the second year following a market crash is
nearly always more variable and bumpy than the first year. The two major
cycles scheduled to bottom at various points in 2010 will be a factor in
producing this anticipated volatility.
While the second year normally shows a
gain for the broad market averages, the gain is usually considerably less
than the first year. At worse, the market trades in a more or less lateral
trend and closes largely unchanged on a year-over-year basis. Accordingly,
technical strategies that utilize trading range opportunities will be
important in the year ahead.
Moving Averages
With the return of volatility
anticipated in 2010, it will be important to have a technically sound trading
discipline. Classical trend line methods can be useful but they aren't
particularly suited for a fast-moving, dynamic market environment. This is
especially true where turning points occur rapidly in a market that is
subject to cyclical crosscurrents as 2010 is likely to be. That's where
moving averages come in handy.
With a good moving average system a
trader can be reasonably assured of catching most of the important moves in
an actively traded stock or ETF while eliminating many of the whipsaws that
attend trading choppy markets. In the book "Stock Trading with Moving
Averages" we discuss some market-tested methods that have proven
successful across most major stock sectors and industry groups, and is
especially geared toward the gold and silver mining stocks and ETFs. Here's
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average series."
Moving averages offer another advantage
over trend lines in that they can be tailored to closely fit the dominant
short-term and interim market cycles. They're also more compatible with a trading
range-type market...if you use the right moving average system. These and
other strategies and tactics are discussed in "Stock Trading with Moving
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Clif Droke
Editor, The Daily Durban Deep/XAU Report
Clifdroke.com
Clif Droke is editor of the weekly Gold Strategies
Review newsletter, published since 1998,which covers mainly U.S. and
Canadian-listed gold mining equities as well as the spot gold market and
forecasts of market momentum trends, short- and intermediate-term. The
forecasts are made using a unique proprietary analytical methods involving
internal momentum and moving average analysis. He is also the author of numerous
top-selling trading books, including "Stock Trading with Moving
Averages." For more information
visit www.clifdroke.com
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