Cue the wise old cartoon owl from the Tootsie Pop commercial: “One, two, three, CRUNCH… it takes three licks to get to the center of a Tootsie Pop.” (Click here for a twisted version of that old commercial
We can always try to find Mr. Owl to ask him how many moving average crosses it takes for a “never look back” bull market to take hold, but we can probably find the answers a bit more easily in the charts.
A Check-In on an Old Study…
Back in 2009 - 2010, when I was doing some joint research and writing with my good friend, David Weigman (he and I used to run ThirdWave Markets, Inc.), we put out a research piece on the time it has historically taken for the market (as defined by the Dow Jones Industrial Average
(INDEXDJX:.DJI) for comparison purposes) to take off and leave technical levels of prominence behind following historic market peaks and the subsequent bear markets.
At the time, we put forth that “technical levels of prominence” for the Dow around the previous historic bear markets were 100, 1,000 and 10,000. The 100 level was first eclipsed in mid-1920s and ran all the way up to nearly 400 before the 1929 crash. The 1,000 level was first eclipsed in 1973 but failed to even make it to 1,000 on that first breakout. The 10,000 level was first eclipsed in 1999 and almost made it to 12,000 before giving way to the bear market in 2000 - 2003.
The point of our research then (and now) was to find out if there were any patterns that could be uncovered that could tell us when it was “safe” to get back in the water for the long-term. In other words, how much time and how many short- to intermediate-term market swings did investors have to endure before they could get long of the broader stock market with great confidence for the long-term?
The technical tools we used for this research were the 200-day and 400-day moving averages. We found that following a historic peak after a break of the key technical barrier, the corrective / base building process would only conclude after three crosses of the 200-day moving average above the 400-day moving average. To more easily demonstrate these three time periods studied below, I’m utilizing the 12-month and 24-month moving averages instead of the 200-day and 400-day moving averages.
The first chart below shows the 1924 -1944 time period, which encompassed the first break of 100 on the upside, the run to a peak in 1929, the initial crash scenario, and then the long recovery phase. Notice that once the market bottomed in 1932, a nice rally ensued where profits were there for the taking. The Dow did run all the way up to nearly 200 in 1937 from the bottom below 50 in 1929 (forcing the 12-month moving average above the 24-month moving average for the first time). However, that was clearly not the end of the macro consolidative process. Another bear market ensued in 1937 and was followed by another 4.5 years of neutral to lower action (where we saw the second 12 over 24 crossover and subsequent give-back). Finally, we saw the Dow bottom out (back below 100 again) in 1942 and start to rally, forcing the key third “12 over 24” crossover to occur. The 1942 bottom was the last time the Dow ever saw 100.
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This was merely one sequence, though. Could we draw conclusions about this 200 over 400 (or 12 over 24) 3-count for future reference? Let’s take a look at the miserable bear market of the mid- to late-1970s. The chart below shows the 1,000 level being eclipsed for the first time in 1972 - 1973. Clearly, there was a nasty 40%+ decline from 1973 - 1975. Although the Dow made several attempts at breaking above 1,000 in 1976 and 1981 - 1982, the breakout that lasted only occurred after the “12 over 24” crossover occurred for the third time in 1983. All the action from 1973 to 1983 was probably tradable for the most nimble and skilled of traders, but the net result for long-term holders of stocks was crummy at best until the breakout above 1,000 finally occurred following the third key moving average crossover.
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So, that was two for two. Unfortunately, in modern market history leading up to the popping of the tech bubble and subsequent recession, those were the only two crash and recovery scenarios that occurred, so it’s a small sample with which we have to deal. The theory behind the need for three key moving average crossovers is backed by common sense, however. After a complete train wreck like either 1929 or 1973, it clearly took a while to rebuild an investor base that “stuck.” That’s not only because of the obvious loss of capital that occurred on the part of investors, but also because of the loss of confidence that occurred. It takes years to build both of those back up, clearly due to the math involved in rebuilding the capital base from the financial perspective. But it also showed an apparent need for some type of economic or geopolitical catalysts to occur to give investors the confidence and/or resolve to stay invested. In 1942, it was the advent of war that spurred on economic activity and patriotism. In 1982, it may
have been the very same factors (that time, it was Reagan’s Cold War efforts versus the Soviets). For me (a technical analyst) to narrow it down simply to geopolitical events as the
catalysts is too simplistic, though. I’m sure it had to do in part with other factors such as fiscal and monetary policies and other factors that may have influenced the “social mood.” Whatever the reasons, the market finally exploded higher in each case after the third key moving average crossover. What about now? Let’s go to the charts.
The chart below shows the Dow Jones Industrial Average from 1996 to current day. Once again, we see the initial breakout above the key technical level (this time 10,000) highlighted in the yellow box. We then got the initial bear market from 2000 - 2003 and the first “12 over 24” crossover that followed at the end of 2003. We obviously saw a low volatility rally that took the Dow all the way up to 14,000 (again, not unprecendented for such a rally to occur; recall the rally from 50 to nearly 200 after the 1929 - 1932 crash). Then, we saw the financial crisis-induced sell-off that took the Dow all the way down to below 7,000. The recovery that has followed generated the second "12 over 24" crossover, but has yet to bring the Dow to new highs despite once again eclipsing 10,000.
If the historical pattern holds true, we could be in for one more drop to slightly below 10,000 before it’s all said and done. Given all of the headlines of the day, it’s not hard to come up with reasons for such a decline. But let’s not get crazy and try to convert our Mayan apocalypse bunkers into market-crash bunkers just yet. This information is just something to keep in mind so as not to get carried away with the bullish hype that frequently accompanies any 5% rally these days. All we can say here is that there’s a realistic chance we see one more dip (causing the 12-month average to dip below the 24-month average) below 10,000 on the Dow.
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The bad news is that such a sell-off may take place. The good news for you is that there are tools out there to deal with that scenario unfolding and protect your capital.
No positions in stocks mentioned.
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