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July 31, 2009

Another bullish indicator

Earlier this week, the Dow gave another bullish signal that the bear market may be over. Or at the very least, that it will be a while before it resumes.

Bloomberg reports on this signal:

The Dow Jones Industrial Average is sending a buy signal that has foreshadowed gains of 18 percent during the past nine decades.
The 30-stock gauge climbed to more than 10 percent above its mean level from the previous 200 days, rebounding from 34 percent below the so-called 200-day moving average in November, according to data compiled by Bloomberg. Eighteen of the last 21 times the Dow rallied from at least 10 percent below the 200-day level to 10 percent above, it posted gains during the next 12 months, Bloomberg data since 1921 show.

Take a moment to look at the table contained in the article linked to above. It shows each of the 21 times this event has happened since 1921, nearly all of which occurred during or near the end of bear markets. Of the three times when the market was not higher a year later, it was less than 4% lower twice (i.e., very minimal losses in the year following the signal). Only once in 21 instances was the market substantially lower (-16.61%) a year after this signal.

For reference, a loss of 16.61% from today's levels would drop the S&P 500 from it's current level of ~989 down to roughly 824. It bottomed at 666 in March. So if the worst of the 21 instances from nearly the past century were to recur, the market would give back roughly half of the gains we've experienced since March. I think that's a dramatically more optimistic "worst case scenario" than most investors are harboring in their minds currently.

(I need to hasten to add that there are no guarantees with the stock market, and certainly none should be implied from my statement above about worst-case scenarios. I'm simply talking about the past record of this particular indicator — obviously the true worst-case scenario is potentially much worse than what this indicator has ever experienced before.)

It's probably also worth pointing out that in all three of the prior worst bear markets of the past century (1929, 1974, 2000), the ultimate bottom was already in place before this indicator triggered. One more reason to think the worst may be behind us.

Pursuing a similar line of thought, Jason Goepfert of sentimentrader.com published a study last week that looked at how long it took the market to fall back below the 200-day moving average after moving 10% above it, as just occurred this week. His study showed that on average, since 1932, it took the market nine months to fall back below the 200 dma. Even more interesting, it showed that the worst-case example took five months to fall back to the 200 dma.

That probably requires a little translating. The 200-day moving average takes roughly 40 weeks of data and averages it, so it isn't very quick to change. So what the paragraph above is saying is that five months is the fastest the market has ever dropped roughly 10% once it got this far above the 200 dma. That's a rough paraphrase, but pretty close to accurate. Five months takes us through the end of 2009.

Again, I think if you asked what the likelihood was that the market would drop 10% from today's levels at some point between now and the end of the year, many investors would answer the likelihood is pretty high. This study is saying that isn't the case, that since 1932 that has never happened in the time frame that would take us through year-end. Kind of surprising, frankly.

Once again, there's no guarantee with this indicator either. Just because it hasn't happened in the past 75 years doesn't mean it couldn't happen this time.

The reason for posting information like this is that there's a very natural tendency to be fearful following severe bear markets. This response causes most investors to miss out on a significant portion of the next bull market. Eventually, the market rallies so far from the prior lows that investors get comfortable that the last bear market really is over. Just in time to get back in near the highs and get trampled all over again.

That's why SMI tends to focus so much attention on purely mechanical signals, like the all-clear indicator, that can give us a stiff shove when we're reluctant to get back in the market after a big loss. We trust those historical indicators more than our own gut/intuition/reason after a big bear market, simply because we know that our emotions will continue to lie to us long after the worst is past.

I'm not saying you should throw caution to the wind. I'm definitely not saying you should take more risk than your plan requires in order for you to meet your long-term goals. But I am saying that it's time to start moving back towards the allocations your long-term plan calls for if you're significantly below those levels. And at a minimum, start giving at least as much consideration to bullish indicators like these and the all-clear signal as you are to any bearish information you're receiving.

The market has gained 4.4% since the all-clear indicator was triggered seven weeks ago. That may not seem like much, but it's an annualized rate of over 37%. For those still waiting on the sidelines, at the very least you need to answer the question, "What needs to happen for me to get back into the stock market?"