Being a student of the stock market means one thing above all else: I’ve studied and experienced enough market history to know what is normal, and what is abnormal, in the action of the market and individual stocks. And it also means that, when some wacky market action drops in my lap, I have a knowledge base to refer to, often finding similarities between the current environment and some episodes of the past.
However–and this is important–I focus solely on the market itself and Cabot’s market timing indicators, or the action of leading stocks. I don’t care much about the news that “caused” the decline, but instead, how the market is reacting to that news.
For example, when last week’s market bombshell hit us, most pundits and commentators immediately pointed to the debt news out of Greece and how it was a continuation of the debt problems that caused the financial crisis in 2008. And that led them to fear a further meltdown. But last week reminded me much more of two other periods that I believe will provide the model for the next few weeks–October 1997 and February 2007.
In both of these cases, the market had the following general similarities with today’s environment. First, both markets featured super-strong advances during the prior couple of months; the advance-decline line for the NYSE was hitting new multi-year highs in each case, there were hundreds of stocks hitting new peaks, and many leading stocks acted well.
And then, after a very brief pause, WHAM!, every case saw the major indexes suffer scary, “biggest drop in many months (or years)” type of declines. Many leading stocks and all the major indexes broke down below their widely followed 50-day moving averages. The volume during the decline was huge. And many investors were shell-shocked … frightened that weeks worth of gains could be wiped out in a matter of days.
Also, in each case, there was widely accepted news that “caused” the event–in 1997 it was the Asian currency crises; in 2007, the crash in the Shanghai markets; and this year, of course, the aforementioned Greece debt crisis.
Underneath the surface, both of the prior instances saw the number of stocks hitting new lows on the NYSE only temporarily expand during the worst of the selloff. In 1997, the Dow actually fell 500 points one day, and new lows jumped above 297, before tapering off in the weeks following.
In 2007, there were a handful of days of greater than 40 new lows, but nothing consistent despite the market’s 6% drop. (Greater than 40 new lows, by the way, is a key level that can differentiate between healthy markets and unhealthy markets. It’s the basis for the Two-Second Indicator used in Cabot Market Letter.)
And this year, when Dow slid as many as 1,000 points last Thursday, there were 218 stocks that hit new lows … but the number dried up to 60, 7 and 8 during the next three days!
In other words, in each instance you had a strong bull market that stepped into a sudden, major ditch. But what happened following the prior two occurrences? The market took some time to build a bottom–about three months in 1997, but just one month in 2007–and then entered into a powerful new uptrend.
While I do not pretend to have a crystal ball, I think there’s a good chance history will repeat itself. Namely, in the short-term, rallies will be sellable, and the volatility that began last week will continue for another few weeks. Translation: Expect lots of choppy action ahead.
During this time, however, we expect many leading stocks (including some new leaders) to build fresh launching pads. The market might successfully re-test last week’s low. And then we’ll enjoy another multi-week spurt higher, led by the best stocks the institutions are buying.
All of this leads to two questions, both of which I’ll answer below.