Are Stocks Gearing Up for Another High?

The market action over the past 4 weeks has erased eight months worth of gains. Does today’s rally mean that the correction is over?

Stocks are rallying sharply today. Does that mean the correction is over? Is today a buying or selling opportunity? History tells us that the biggest rallies have occurred during the most vicious declines. Nine out of the ten biggest Dow percentage gains occurred during the Great Depression or in September/October 2008. Admittedly, today's rally does not qualify as a huge rally, but what about the 405-point rally on Monday, May 10? On May 14, the ETF Profit Strategy Newsletter offered the following research: “Monday's (5-10-10) trading session added another 405-point bounce to Thursday's rebound. At first glance this seems bullish. But, history tells us it's not. We've found 16 instances where the DJIA rallied 400 points or more, 12 of them hit during the post-2007 decline, most of them in September/October 2008.” Since then, the S&P has fallen as much as 10%, the VIX (Chicago Options: ^VIX) has soared as much as 71%. The iPath S&P 500 VIX Short-Term Futures ETF (NYSEArca: VXX) bounced as well. fter forecasting a fall below the May 6 low of S&P 1,066, the ETF Profit Strategy Newsletter sent out the following note yesterday (5-20-10): “We do well to remember that this period of time (September/October 2008) hosted some of the most powerful counter trend rallies ever recorded. There is a chance that we will see similar ‘explosions’ to the upside over the next days and weeks. If we do, we view them as opportunities to add more short positions.” Similar to just a few weeks ago, rising prices are likely to lull investors to sleep once again. Lulled to sleep No doubt the financial media played a big role in lulling investors asleep. The April issue of Newsweek exclaimed: “America is Back.” But Newsweek wasn’t alone. Below are headlines from April 26, the day the S&P peaked: Bloomberg: “U.S. stocks cheapest since 1990 on analyst estimates.” Bloomberg: “Biggest banks are back as JPMorgan, Citigroup turn corner on credit crisis.” Wall Street Journal: “Consumer mojo lifts profits.” Wall Street Journal: “Technical analysts see room to roll.” Jon Markman on Yahoo Tech Ticker: “S&P could hit 3,000 by 2020.” On April 7, the Wall Street Journal touted: “Dow 11,000 is only the beginning.” Quite to the contrary, the ETF Profit Strategy Newsletter went out on a limb and noted on April 28: “With various sentiment gauges having reached multi-year extremes and Investors Intelligence bullishness at 54%, the potential exists that Monday’s high – which was only one point short of the 61.8% Fibonacci retracement at 1,220 – marked a significant top.” Since then, the major indexes have lost over 10%, the most since the beginning of this monster rally in March 2009. In fact, the S&P is trading at the same level today as it did on September 17, 2009. The last 19 trading days erased over eight months of gains. Wow! How much lower can stocks go? You may want to sit down for this one. There are different methods to ascertain the markets outlook. Historical precedents and technical indicators are two we’ll discuss here today. Below the 200-day moving average Some swear by moving averages – especially the 200-day one – others dismiss it as a lagging indicator. However, it’s not important what you or I think, it’s important what the big players think. And the fact is that many institutional investors base their buy/sell decisions on the 200-day moving average. A solid close beneath the 200-day MA often triggers sell orders across the board. On Thursday, the S&P 500 (NYSEArca: SPY) closed below the 200-day MA (1,102) for the first time in 216 trading days. This is bad news, especially since there was no resistance. Once below the 200-day MA, the S&P fell another 3% in one day. The Nasdaq (Nasdaq: ^IXIC), one of this year’s leading performers (at least for the first four months of year), also closed below the 200-day MA, as did the Financial Select Sector SPDRs (NYSEArca: XLF) and Technology Select Sector SPDRs (NYSEArca: XLK). In short, breaking below the 200-day MA is bearish, but it doesn’t tell us how far stocks will fall. We’ll have to look elsewhere for that. Historical extremes There were literally dozens of sentiment and technical extremes that occurred right around the April 2010 top. These extremes moved the ETF Profit Strategy Newsletter to point out on April 16 that “historically, there has rarely been a more pronounced sell signal. Aggressive investors may choose to act on it.” ETFs recommended included the UltraShort S&P 500 ProShares (NYSEArca: SDS), UltraShort QQQ ProShares (NYSEArca: QID), Short Dow30 ProShares (NYSEArca: DOG) and many others. Due to the markets recent performance and ability to reach multi-decade extremes it becomes fairly easy to isolate historical precedents. From October 2007 to March 2009, the Dow Jones (DJI: ^DJI) dropped 53.77% or 7617 points. The only historic parallel that measures up to this kind of drop is the 1929 decline, which reduced the Dow by 48%. The 71.15% rally from March 2009 to April 2010 can only be compared to the September 1929 – April 1930 rally, which lifted the Dow 49% in a matter of eight months. This 8-month counter trend rally inspired the same kind of optimism we saw just a few weeks ago. Below are some comments and headlines taken from early 1930. Deja vu of enthusiasm Irving Fisher, Ph. D. in Economics: “For the immediate future the outlook is bright.” Harvard Economic Society: “ There are indications that the severest phase of the recession is over.” Andrew Mellon, Treasury Secretary: “There is nothing in the situation to be disturbed about.” Julius Barnes, head of Hoover’s National Business Survey: “The spring of 1930 marks the end of a period of grave concern. American business is steadily coming back to a normal level of prosperity.” Just a few weeks after the above assessments/forecasts were spoken, the Dow started its long and painful descent – it dropped an additional 86%. Of course, Wall Street always says, “This time is different.” Historic patterns show us that exactly this frame of mind has proven fertile soil for declines that are not different at all. Motivated by this spirit, the biggest Dow percentage gains were recorded during the Great Depression and the September/October 2008 meltdown. The “this time is different” spirit is most pronounced during periods of big declines and lure investors back into stocks just to experience yet another beating. Fool me once, shame on you, fool me twice … Great Depression historian and author John Kenneth Galbraith described the allure of a rally market during the 1930s as follows: “The worst continued to worsen. What looked one day like the end, proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few people as possible escape the common misfortune. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall. The bear market was a remarkable phenomenon. The ruthlessness of its liquidation was, in its own way, equally remarkable.” The market decline from 1929 – 1932 erased 29 years worth of gains. In March 2009, the market had erased 10 plus years worth of gains. According to some research, the decline of industrial production and world trade during the first nine months of the post-2007 bear market has been more pronounced than during the 1930s. Unemployment has hit the highest level since the 1930s. Based on the giant gyrations of the post-2007 bear market, there is a good chance that more than 29 years of gains will be erased.