Party Like It's 1938

07/20/2009 12:00 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, says the market bears a strong resemblance to 1938’s, and he looks at some recent trends to forecast its direction…

The bears finally seized their opportunity once resistance held at 930, and they forced the Standard & Poor’s 500 index ($SPX) all the way down to the bottom of its wide 880-950 trading range. We consider it necessary for $SPX close decidedly below 880 in order to confirm a downside breakout. Eventually, we expect a major correction, but not necessarily at this time.

The equity-only put-call ratios continue to rise and are thus still on sell signals. Since they started from such a low point on their charts, they have a long way to roam on the upside before we would consider them “oversold.” Market breadth turned decidedly negative [about a week ago], as the market sold off.

Volatility indices moved higher this week. Once again, the VIX has broken up through the down trend line that has defined its intermediate-term decline since the March $SPX lows. If VIX truly does break out on the up side, that would be negative for the stock market. A close below 29
would return the VIX to a bullish indicator. (It closed below 29 every day last week—Editor.) VIX futures generated sell signals over the past month or so.
 
In summary, the bulls may attempt a rally here, but we would not expect it to be particularly robust—probably just enough to work off the oversold condition in the breadth oscillators. Thereafter, unless the indicators quickly change, we expect a down side breakout to occur.

For some time now, we have been comparing the year 1938 with this year. Everyone knows that the Great Depression drove the stock market down dramatically, to a low of 40 on the
Dow Jones Industrial Average in 1933. There was a strong rally for the next few years, but by 1937, the economy was in trouble again. In fact, it would have been labeled another “depression,” except for the fact that the Roosevelt administration invented the word “recession” to describe it.

In any case, this time (1937-38), President Roosevelt became a true Keynesian–at the urging of John Maynard Keynes himself–and the money floodgates opened (much as they have done now). The stock market suffered badly in 1937 and dropped sharply into March 1938. Then the effects of the money flood took place, and the Dow rallied 58% from its March low to its November high.

[There] were two very strong rallies, from which point there was a 10% correction through September. Then, one more strong rally took the market to its ultimate peak. After that, the market never saw that level again for another seven years, and eventually it drifted down lower.

A 58% rally off this year’s March lows would put $SPX at about 1050. That seems to be a reasonable target for highs of this free money-drunk market.

Subscribe to The Option Strategist here…

Related Articles on MARKETS