Bear Markets and Historical Regression

07/29/2015 8:00 am EST

Focus: STOCKS

Alan Newman

Founder, Crosscurrents Publications, LLC

As a consequence of the modern era and high frequency trading, traditional valuation measures have become relatively meaningless, cautions Alan Newman, editor of CrossCurrents.

Further, mutual funds now hold as little cash as possible in reserve. They are near fully invested and will lose more in a market decline and be less able to take advantage of lower prices when a bear market eventually provides compelling values, as typically occurs. 

We find it valuable to occasionally look at the Dow Industrials dating back over a century relative to its 5% regression line. 

Going back to 1890, the Dow has averaged annual gains of roughly 5% ex-dividends, thus, we believe a 5% regression line is a fair representation of normal market return expectations. 

Surprisingly, the Dow has been below the line 74% of the time. This seemingly weird circumstance simply mirrors what we know about markets.  Bear markets tend to greatly overdo the downside and this factor tends to keep the Dow under the regression line longer than one might expect. 

There have been only four occasions in which the Dow has greatly exceeded the regression line on the upside. The first was during the Roaring Twenties, arguably the biggest mania of all time. 

As stocks peaked in 1929, our indicator soared to 86% above the line. The 1929 high was not exceeded until 1955 and the super bull market did not begin until August 1982, thus the Dow remained below the line for decades, finally rising above in 1996 as the tech mania approached.

How amazing was the tech mania?  Our indicator ran to almost exactly the same level as in 1929. The third peak arrived in July 2007, when both housing and stocks were in manic mode.

And now, the present overbought condition has taken us almost 37% above the line.  Bear in mind, this is only the fourth time we have seen this circumstance and each of the prior circumstances resulted in a horrific bear market.

The Roaring Twenties resulted in an 89% decline in the Dow.  Stock prices fell 50% from the tech mania peak and 50% again following the busted housing bubble.

The dénouement need not be an exact replay of any of the cited prior bear markets. However, we believe this period is at least as dangerous as March 2000 and October 2007.

Although our present downside bear target is Dow 14,719, we would caution that a scenario in which prices briefly dip to the 0% line would take us to under Dow 13,500, a decline of roughly 25%.  

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