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Time for a Dow Correction?

Historical Patterns Indicate an End to the Bull

Written by Briton Ryle
Posted May 17, 2013

Ready for a little rear-view mirror driving? Though a stock market’s past performance is not always an indication of future movement, if a pattern repeats itself enough it can make a pretty compelling case.

Looking back through the years, one can find countless patterns and cycles in the performance of stock markets. Eventually, all patterns break down and transition into new ones. These transitions occur whenever there is a major macroeconomic change, such as a recession, a boom, a major war, or a major new technology (ie: Internet).

Yet during those stable periods between major economic changes, stock market patterns remain remarkably constant.

It’s kind of like the weather. Weather patterns change from season to season. But within each of the four seasons, you can reasonably expect the same general weather pattern to remain in place until the season changes.

Since bottoming in the spring of 2009, U.S. stock markets have been in a unique season, distinct from any other season in the past -- one marked by steady stimulus from the U.S. Federal Reserve and steady ultra-low interest rates. It is not surprising at all, then, that within this 4-year-long “stimulus season” we find one very reliable repeating pattern throughout.

Using Historic Foundations

The pattern particular to these recent stimulus years is – as all other stock market patterns are – based on core historic foundations that persist year after year. In the case of the U.S. stock markets, the main die-hard historic foundational pattern consists of an annual advance (late-autumn, winter, and early spring) and an annual retreat (late-spring, summer, early autumn).

Although the precise timing of the start and end of each phase varies from year to year, typically we find that the October/November to April/May period has an upward bias, while the May/June to September/October period has a downward bias.

This historical pattern includes a corrective reversal in the middle of each leg. In the middle of the bull leg, the month of February is typically bearish. In fact, according to the Stock Trader’s Almanac, February is the second worst month of the year – right in the middle of the bull run. It makes sense to have a little bit of a breather right about there.

As expected, the bear leg has a corrective reversal of its own at about its middle, the month of July. According to the Almanac, July on average beats every month from May to October, inclusive.

Using this underlying historic pattern that has been repeating for decades as a base, the current stimulus season superimposes its own unique pattern that has repeated in each of its four years almost precisely on cue.

3 Steps Forward

Most of us may already be aware that the S&P 500 index is a truer gauge of the overall U.S. stock market’s performance. But I still like the Dow because it is typically a little more volatile than the S&P. And those slight extensions to the upside and also to the downside permit the locking-in of just a little more profit. So I’ll use the Dow index out of habit.

dow chart 1 5-17

The wintertime bull runs in each of the four years of the stimulus season since 2009 started and ended remarkably on cue, as shown in green above: 1. – July to May, 2. – July to May, 3. – October to May, and 4. – June to present. (We could consider the run of 2011 as having started in August if we really wanted to force the point.)

Do you notice how long each leg ran? 1. – 3,000 points, 2. -- 3,000 points, 3. – 2,500 points, and 4. – 3,000 points so far. Again, it seems 2011 is proving to be an individual by marching slightly out of step with the group. But it did make an effort, and we’ll consider it satisfactory.

2 Steps Back

The annual up-leg is followed by the annual down-leg in a healthy “correction” or sometimes smaller retracement.

dow chart 2 5-17

Each of the stimulus season’s 3 corrections so far (red) have started and ended almost precisely on cue: 1. – May to June, 2. – May to August, and 3. – May to June. Once again, 2011 marched as an individual, where the month of July took seriously its historical role as the mid-summer upward reversal, which prolonged the overall correction and dragged it into August.

Consistent too is the point at which each correction stopped (yellow). It is very typical for downward falls to stop at places where prior upward rises paused. It is another one of those historical foundations, where the ceiling becomes the floor.

In our current stimulus season since 2009, all three corrections stopped at a concentration of ceilings near the beginning of the previous upward run: 1. – stopped at 9,700 near the previous August/September ceiling, 2. – stopped at 10,750 near the previous August ceiling, and 3. – stopped at 12,100 near the previous October/November ceiling.

Well, well, what have we here. 2011 is still marching out of step with the group again. Still, there was a prominent August/September ceiling, even though it was never used as a floor.

Piecing It Together

Now that we have all the needed data points, let’s put them all together and formulate a projection for the Dow.

dow chart 3 5-17

As measured by the first two metrics of timing and duration, we see that the markets have as of this week satisfied both. Into the month of May, the up-leg has run 3,000 points. According to the stimulus season pattern, then, the current run up in the markets seems to be ready to pause.

However, seeing as the 2011 run undershot by 500 points, we could expect the upward run to have a 500-point margin on either side of the bull’s eye. The current run up may overshoot by 500 points, or it may even touch that psychological 16,000 on the Dow. If it does, it shouldn’t remain there for long before the next two metrics take over.

The third metric tells us to expect this year’s summertime correction to run from May/June to August/September, with a typical July reversal in the middle, while the fourth metric puts the support level of that correction at the 13,500 area on the Dow, which was the prior September ceiling. If it falls through that support level, the Dow should stop at the July-August ceilings between 13,000 and 13,250.

Unique Features

What makes this current stimulus season since 2009 unique is that while each upward run is pretty consistent at 3,000 points, in percentage terms the runs are getting smaller. This is probably because stimulus is having less and less of an effect, kind of like multiple antibiotic injections have a gradually reducing benefit.

Another unique feature of this 4-year stimulus season is that markets have been able to rise despite slow economic growth and jobs recovery. Again, this is thanks to the stimulus, which makes the grouping of these last four years into a season of their own all the more necessary to distinguish this period from all the other periods in stock market history.

At the same time, however, there is a feature that is not very unique to the stimulus season at all – namely, that trading patterns are just lines on a chart like borders on a map. Nature is not bound by borders, and markets are not bound by charts.

Besides, who is to say that I have even drawn these lines in their rightful place? I could be off by miles.

When it comes to investing in the stock market, although past patterns and technical analyses can provide a general guide, no technical study should ever substitute careful research into underlying stock fundamentals.

When selecting a company to invest in, make sure it has plenty of market share, plenty of products or services in demand, and plenty of cash on hand. All the rest is just an academic exercise designed to educate. And all knowledge is limited by the unknown.

Joseph Cafariello

 

*Charts courtesy of BigCharts.com

 

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