by Daniel Putnam | August 16, 2011 12:12 pm
Stocks have rebounded nicely in the past few sessions, but that doesn’t mean that it’s time to get carried away. A look at the major market bottoms of the past 25 years shows that the initial downdraft typically brings a relief rally like the one we’ve seen in recent days.
However, this bounce is usually followed by a second downleg that takes the major indices to lower lows – making the shape of most meaningful bottoms look like a “W” rather than a “V”. Given the macroeconomic issues that continue to weigh on the market, it seems likely that a similar scenario will play out this time around.
Let’s look at the historical record of major bottoms, as gauged by the S&P 500 Index. First up is October, 1987 – a drop that was much quicker but similar in magnitude to the downturn we just experienced. The initial rally was short-lived, lasting only two sessions before the S&P gave back 11%. The subsequent basing process lasted over a month and a half, and the market didn’t hit bottom until it exceeded the closing low of the October crash.
The charts of 1990 and 1994 show similar – albeit less dramatic – patterns, with the initial bounces lasting only three and five sessions, respectively, and the final lows occurring about two weeks after the first portion of the W was established.
The post–tech bubble crash paints a somewhat different picture, with a more complex W and an additional downleg that brought the market back near its prior lows a full eight months after the initial phase of the selloff. Still, the chart demonstrates the unreliability of the initial lows.
The final chart illustrates the bottom that formed following the 2008-2009 bear market. Here, we see two false bottoms being put in, the first in early October and the second in late November. Not until March 9, nearly five months after the initial downward thrust, did the market finally embark on a sustainable rally.
The point of this excersise is to point out the high level of caution that is required now that stocks are in the fourth session beyond last week’s initial panic bottom. While it’s possible that the market could surprise us by forming a “V” and immediately surging back toward its previous highs, history shows that such an occurrence would be very rare.
One argument against this assertion is the fundamental picture. A number of analysts and major financial publications have pointed out that stocks are attractive in terms of yields, valuations, and balance sheet strength, and that there is room for substantial upside if the economy does not in fact fall off a cliff in the months ahead.
That may be so, and it’s certainly a case for owning stocks once we move into the traditional period of strength in the November–January interval. However, the technicals are the true driver of market performance right now, possibly due to the increasing role of high-frequency and algorithmic trading in day-to-day market movements. Consider, for example, that the S&P 500’s low of last week occurred almost exactly at the 0.38 fibonacci retracement from the March 2009 low to this year’s May 1 high. This type of market action indicates that investors will be well-served to keep their eye on the charts here.
The bottom line: we probably won’t see the true low for at least several more weeks, so don’t hesitate to take any profits and/or establish portfolio protection before the current relief rally loses steam.
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