A historic level of fear, even panic, has developed as forced liquidation is removing some players from the market completely. Another difficult lesson in leverage and risk management for some really bright folks. Brings to mind one of my favorite quotes, compliments of John Maynard Keynes, “The market can stay irrational longer than you can stay solvent”.
Irrational may be a mild description for what we’re seeing in the markets currently. After a 1,000 point range on Friday from top to bottom, the Dow Jones Industrial Average added almost another 1,000 points Monday. Clearly the selling was overdone on the downside and the market was drastically oversold after a 3,000 point decline from top to bottom in the previous eight trading sessions. Thankfully, those nasty shorts decided to take some profits and get the rebound started Friday morning.
We wouldn’t consider this the all clear signal however. Historically, a retest of the lows develops within a few months to verify the strength of the bottom. Hitting the exact lows again is not a necessity, but a second significant down move usually at least comes close. This offers a great time to pick up relative strength leaders as they separate from the pack.
The correlation noted in Here we are again? 2001 vs. 2008, Is it really 2001 again? and Back to the future again and it’s not pretty has finally culminated in the fear based washout we have been looking for. Admittedly, it was at much lower levels than we expected, but the timing was almost perfect. The rebound in 2001 started on the morning of Friday, September 21 at 944.75 on the Standard & Poor’s 500 (SPX). The rally continued on Monday and Tuesday of the next week, covering a respectable 75.54 points or 8% from the lows. Another 20 points were added by the close of the week after a brief rest on Wednesday and Thursday. By the end of the following week, another 30 points had been added (for a total of 126.63 points or 13.4%, from the lows). Two weeks later, the net gain was flat after a brief run over 1,107. Sideways trading then developed until a clear break over 1,100 in the first week of November. Around Thanksgiving, the new high of 1,163 had brought the market back from the lows by over 23%. The rest of the year saw a peak gain of only 10 more points in the first week of December. A final 3.5 points was all that was left for the first week of the new year, as an intermediate top at 1,176.97 was found. That top was tested again in late March of 2002, after a 100 point (8.7%) drop into late February. That was all she wrote for that bounce however, as the SPX found new lows at 768 in October, finally the low for the entire bear market. Patient buyers were rewarded as the final retest of the lows completed a massive head and shoulders bottom in March of 2003 at 789.
In 2008, the rebound started on the morning of Friday, October 10 at 839.80 on the SPX, almost three weeks behind schedule. So far, the monster rally of Monday, October 13 has added 167.13 points or 19.9% from the lows. A morning look at the futures market suggests another 20 or so points may be in the works for Tuesday. In just three trading days, this bounce has covered almost the entire distance of the rebound in 2001-02, on a percentage basis. The preceding decline was also much more violent as the SPX dropped from 1,300 to the lows at 839.80 (35.4%) in just six weeks. In 2001, the fall drop was 28.2% over 16 weeks.
What Does it All Mean
If history holds, only a small portion of this bounce is behind us and there will be plenty of opportunities to get in at decent prices. The first leg of this rally is past, but the second leg could be just as profitable. At the very least, consolidation will develop following these monster gains. This will give nimble traders the ability to buy the dips. Long term investors are almost guaranteed to get another chance at prices near the lows in the coming months. The key is to watch overhead resistance, and there is a ton of it. Fibonacci retracements, moving averages and previous lows all will take their bite from the rally. Don’t forget The Significance of the 400 day (80 week) moving average indicates we are still in a bear market. No other long term indicators have given buy signals either.
One more market comparison to consider is the crash of 1987 which found its low on Tuesday, October 20. This price action may actually be more appropriate considering the violence of the decline. This October “crash” market dropped 35.9% in 8 weeks, bounced 19.8% in two days, then dropped back to within a few percentage points of the low in early December. The market then totally recovered within two years.