It Looks Like a "V," but Is It?

08/12/2009 12:00 pm EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, managing editor of Investment Quality Trends, says market history may offer a clue to whether this is the end of the bear market or not.

My, oh my, how the worm of sentiment has turned. It was mere weeks ago we were talking folks off the ledge [who] were hanging on by their fingernails; now, they’re asking if it is time to bet the ranch and leverage up 200%.

While we welcome the declining effect of gravity on stock prices, we remind [you] of the importance of perspective and historical context. For this reason, we suggest another look at the Dow Jones Industrial Average from 1969 through 1978. [It] clearly illustrates how past secular bear markets have moved in successive waves of decline and retracement until the primary trend is exhausted.

The DJIA peaked in early 1969 just below the 1,000 level. By mid-1970, the index had declined to the low-600 area. A sharp reversal to the up side ensued at this point, creating the V pattern discussed [here recently]. In mid-1971, this retracement came very close to the high established in 1969 before reversing course once again.

The next down leg ended in late 1972 without making a new low. Many analysts and investors felt this was the end of the bear market, particularly since the retracement that followed exceeded the 1969 high. To [their] surprise, the market reversed yet again into the sickening third leg down that came to an end in late 1974 at what proved to be the final low.

The period from 1975 through late 1982, when the great bull market began, is illustrative of the typical consolidation period that occurs after a secular bear market, because sentiment from disbelieving investors remains at negative extremes.

No secular bear market in history has ended with a “V” bottom reversal, [although] there is a first time for everything. At the time of this writing, however, the breach of the 9,140 level on the DJIA merely represents a 30% retracement of the decline from October 2007 to the reversal in March of this year, so keep this in perspective.

Referring to 1969 through 1978 again, retracements can approach the previous high or, in the case of 1973, eclipse the previous high before reversing course once again. Historically 30% to 50% retracements are quite common.

The second retracement objective of 50% of the decline would be achieved at Dow 10,300, an increasingly attainable target that could manifest in early October.

While we enjoy this change in fortune, it is important to continue to walk through the shallow end and observe the rules of good stock selection: restrict purchase considerations to stocks that represent historic good value; and, diversify, diversify, diversify. Until proven by further evidence, however, the primary trend remains down; the judicious uses of dollar-cost-averaging and stop-loss orders are entirely appropriate.

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