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Posted: April 21, 2009

Has the market bottomed or bounced?

Looking for the big "W" -- a historical perspective

Dominick Paoloni

Remember the 1963 movie, “Mad, Mad, Mad, Mad World” staring Spencer Tracy, where a group of misfits race to find the Big “W” – an icon under which a large sum of money was buried?

This movie could stand as a metaphor for the current state of the US stock market. Based on historical stock market evidence, if we can find the big “W” then profits in the market will follow.

Since March 6, 2009 the Dow Jones Industrial Average,  as well as other major markets around the world, have been in strong rally mode, with most of the media espousing the view that the bottom is in and you should “buy, buy, buy” before you miss the opportunity. 

We have heard these cries before. Historically, all bear markets since the Great Depression have seen fierce bounces, creating euphoria that was crushed as the market collapsed back down to lower lows. The starkest case, the 1929 crash, when the Dow lost 48 percent of its value only to rally back 48 percent over a six month period and create a surge of optimism. By the middle of 1932, the markets were down over 89 percent.

So the million-dollar question, “Is the rally that began on March 6 really the beginning of a bull market, or is it a “sucker’s rally,” commonly referred to as a bear market trap?”

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Winston Churchill once said, “The best way to predict the future is to study the past; those who do not are doomed to repeat it.” Taking Churchill’s advice, IPS conducted an in-depth study of all bear markets since the Great Depression to see if there are any common links that denote a market bottom.  

What became evident from the data of previous bear market bottoms is that they all experienced the same price movement that signaled the end of a bear market.

Including the Great Depression, the market has had 14 bear markets. All 14 out of 14 bear market bottoms ended with a double bounce, a formation that looks like a big ‘W”.

In fact, since the Great Depression, if the market (Dow Jones Industrial Average) didn’t retest the previous market lows within 6 percent, then all rallies were bear traps. In other words, all market rallies that were bouncing off a lower low were a sucker’s rally.  

The rally started on March 6, 2009 from a low of 6547 and the previous low in the market was Nov. 20, 2008 at 7552.  If history is a guide, for the current rally to be the start of a bull market, the March 6 low would need to be approximately 6 percent or less from the Nov. 20 low. The percentage difference between Nov. 20 and March 6 is more than 13 percent, nowhere close to the plus or minus 6 percent range established in the study. This would conclude from an historical perspective that the current rally is a bounce not a new bull market.

The study shows strong quantitative evidence that the current rally is just a bear market trap unless the market retests the March 6 low and holds (within 6 percent or less).  However, there have been times in history when the market retested a bottom, held and then later went to lower lows. In conclusion, even though every bear market has ended with a double bottom, a double bottom doesn’t mean the market can’t later go to lower lows.

Qualitatively, the government has never thrown so much fiscal stimulus into the economy in such a short period of time. This could be a justification why historical data may not hold. This stimulus could make this bear market rally different from all the others; the market could enter a bull market without retesting a bottom.

The technical quantitative evidence is strong that the market is going to lower lows, which will happen if the adrenaline shot of economic stimulus wears off and doesn’t have the desired effect. If that is the case, watch out below.    

Dominick Paoloni is a registered investment adviser and a wealth manager. He can be reached at (303) 697-3174 or dominick@investps.com or visit the website at www.investps.com .

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