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A Plunge to New Lows as a Good Sign July 16, 2006
The world can be a cruel place.
Sometimes, we have to hit a new low point before we can go on to bigger and better things. For me, that moment came in January 2001 - I was "stuck" in a good job that I hated, my beloved father-in-law had just passed away, and my wife and I lost our baby son after 18 days of struggle due to prematurity.
While it seemed impossible at the time, the darkness did eventually lift. We all go through these cycles of scaping along at the bottom, then rising to new heights - perhaps that's why negotiated markets do as well. After all, they're just a reflection of our current perceptions.
So the new lows that we're seeing now in some sectors might not be the beginning of the end, but rather the necessary purging that needs to be done before we're able to rise again. It always seems impossible and counter-intuitive at the time, but as we'll see below, the market hitting a new low is sometimes precisely the event that triggers a new leg up.
Before we take a look at that phenomenon, however, I want to go over a couple of things that we discussed extensively a few months ago.
Throughout April and May, I showed several studies that suggested the reduction in bullish expectations was not the "wall of worry" that bull markets climb, but rather a very bearish reduction in investors' risk appetites that likely portended a difficult summer.
One of them, from May 16th, concerned the fact that the percentage of stocks on the New York Stock Exchange hitting a new low reached 5% of total issues, after the Dow Jones Industrial Average had hit a new yearly high only a few days before. On average, the Dow fell a little more than 5% over the next one to three months.
It's been almost exactly two months now, and the Dow is about 6% lower - very much in line with what the precedents suggested. But here's the curious thing...if we go back to those six occurrences and see what happens when we buy the Dow two months later, this is what we get: over the next three months, the Dow was positive 5 of the 6 times, by an average of just over 5%. The one negative return was -2.4% (which would have turned positive quickly thereafter), while two of them showed returns in excess of +12%.
One of the other themes that I concentrated on was the comparison of our technical situation to that of early 1994. The similarities were so numerous that it would take me a few paragraphs to go over them all, so I'm not going to bore you by re-hashing them - you can browse through the comment archives from this spring and pick them out.
Coincidentally (or perhaps not), the similarities continue.
Let's take a look at the Nasdaq Composite index from the spring of 1994:
We see that all the same kinds of forces that were building up to the break over the past few months were taking hold then as well, and it manifested itself in a sharp 12% drop over a month's time, then a 5% rise over the next month, then one last 7% cut lower to a new 52-week low. After that...well, we'll take a look at that a little bit later.
Now let's compare that to the Nasdaq Composite today:
If we push 1994's time frame ahead by about a month, then we get a very close comparison, even down to the time of year. We got an initial 12% drop over about a month, then a 5% rally, and now another 7% decline (so far...).
There are, of course, some ways in which our current situation does not at all fit the 1994 template, and I don't want to carry the comparison too far. But it's also interesting that along with the almost perfect fit with the Nasdaq Composite between then and now, we also saw a somewhat similar pattern in the S&P 500.
In '94, the S&P had rallied into June, then went through a quick 4% decline over about a week's time...but it made a higher low while the Composite was hitting its 52-week low. Now, we've gone through almost the same scenario as the S&P has declined around 3% over the past few days and (so far...) has remained above its June trough.
Oh yeah...and the Composite is very, very close to a new 52-week low.
A New Low in the Nasdaq Composite May Not Be a Bad Thing
Let's investigate that a little more closely. It's been over three years since the Composite has suffered the indignity of being listed in the "new low" column of the local paper. That's quite a streak, and over the 35-year history of the index, something rarely matched.
But it has been matched, and it might be instructive to see what happened the four other times in its history that it went at least three glorious years without hitting a new rolling 52-week low in the interim.
First, 1980. The Composite had managed to last 1,384 days without hitting a new 52-week low, but but on March 26, 1980, it did just that:
The odd thing is that despite all the hand-wringing about the first new low in over five years, the index bottomed the very next day and went on a fantastic run, tacking on another 58% one year later.
Fast forward now to 1987. The market had been on another great run (lasting 818 days without hitting a new low), but then we dropped dramatically leading up to Black Monday. On that day, the Composite eclipsed its low from the previous December:
Some hall-of-fame traders like Paul Tudor Jones were able to navigate the terror and profited handsomely, but most panicked in the days ahead and drove the index down temporarily. It took another 7 days before the Composite hit its low, but from the close on Black Monday, was still able to record a nearly 7% return over the next year.
Now let's skip ahead another seven years or so to our old buddy, 1994. From the beginning of this comment, we know what happened during the spring and early summer. On June 23rd, the Comp fell below the April lows (that traders had thought was THE low), and set a new 52-week low in the process for the first time in 932 days:
Once again, the new low proved to be a point to not panic, as the Comp formed its low the very next trading day, and jumped over 30% in the course of the following year.
For our last precedent, we're going to visit 1998. This time the Composite lasted 1,056 days without seeing a 52-week low, but that ended on August 28th in the midst of trouble in Russia:
Curiously, we once again see that the index was able to form a low the next trading day. It soared 17% over the next month before another gut-wrenching short-term haircut, but from the date of the new low on the 28th, it ran 68% over the following year.
It's always tough to put a lot of faith in just four historical precedents. The reason I bring them up is due to the intriguing consistency in when the Composite formed a low. All of them were significant in that we had gone at least three years before seeing a new 52-week low, and at the time of the low, we can just imagine what traders were thinking. Surely, "the bull market is dead" was on nearly every one of their lips.
Conclusion: If the S&P Can Hold While the Composite Makes A New Low, We Should Still be OK
In the comment posted on Tuesday, I noted that given the other precedents of the TICK cluster we saw that day, it was important to watch Tuesday's low in the S&P 500 - if it failed, then we should be in for several more days of selling pressure.
Those precedents ended up being a good guide, as we have undergone almost the same fate. Both of the other instances where the low failed ended up leading to about a 50-point decline in the S&P from that day's high, and we just about matched that this time around.
According to our sector breadth charts, on Friday only 6% of the components in the Nasdaq 100 closed above their respective 10-day average, and 10% closed above their 50-day. That's a special kind of washout, and it's been rare to see over the past decade.
We saw it last month on June 12th, and the NDX managed to rise about 5% before rolling over into the current decline. Historically, the average maximum gain over the following month is four times higher than the average maximum loss.
If we're in a new bear market, then there is extreme danger in trying to buy into new lows based on oversold types of indicators. But I think it's still too early to suggest that that's the case, as based on most objective measures we can't make that determination yet.
If the Nasdaq Composite happens to hit a new 52-week low early this coming week, and the S&P at the same time manages to hold above its June trough, then I will become increasingly intrigued by the 1994 precedent, along with the three other times that index hit a new low after three years of not having seen one. In three of the four cases, the Comp formed a bottom one trading day later, and it's something I will be watching with extreme interest this week.
Obviously, the developments in the Middle East could hold great sway in how eager traders are going to be to put capital at risk. The last time Israel invaded Lebanon, on June 6, 1982, the S&P 500 dropped 1.6% heading into the weekend. We then had two months of basically going nowhere until a final drop into August when the PLO withdrew from Lebanon (which coincided with the last low before the great bull market in equities).
With what looks like an impending war, and an earnings barrage starting mid-week, we are going to be subject to overnight gap risk, and we will likely see volatile intraday moves based on the scrolling news headlines. It will be a tricky week. Home | Commentary | Indicators | Models | Sectors | COT | Subscribe | About Us
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