A Lesson in Market History

May 4, 2009
Mike Doran

Using historical charts as a guide for future price direction can be a good way of understanding where we may be headed next.

A Quick Recap

The major Indices continued their two-month advance albeit with less momentum and most of the gains coming on Wednesday of this past week. The S&P 500 finished the week up +1.3%, Dow +1.7%, Nasdaq +1.5%, Russell 2000 +1.7%.The market continues to absorb good and bad news well, discounting a potential swine flu pandemic, a worse than expected GDP number, Chrysler's bankruptcy and an announcement of the delay for the release of the government's bank stress tests on Friday. Bank of America (BAC) and Citigroup (C) may need to raise billions of additional capital based on early results of the tests.

Looking ahead, economic data will be light with ISM services, initial jobless claims, and earnings announcements for 84 S&P companies. Investors may finally see the results of the government's bank stress tests late afternoon on Thursday and Nonfarm Payrolls (unemployment) report for April will cap the week on Friday.

A Lesson in Market History

Using historical charts as a guide for future price direction can be a good way of understanding where we may be headed next. I give a lot of credit to Bill O’Neil, publisher of Investor Business Daily and his research team for their excellent record of using historical context to help demonstrate possible scenarios which may manifest in the market's future. In our previous blog post on 4/13 we showed you the Nasdaq chart compared to the Dow Market bubble and crash from 1922 to 1946.

Let's take a closer look at the weekly chart of the Dow Jones Index from 1938 (shown below). From the low of 97.46 on April 1, 1938 the Dow had an automatic rally of 27% in just 4 weeks. This is remarkably similar to today’s market where the S&P 500 began to rally the week of March 13 and over the past 5 weeks has rallied 871 points or 30%. Thus far, the rally has been fueled by weaker stocks emerging from the ashes of an extremely decimated market (some call this a "dead cat bounce"). Our work is showing that until all major indexes take out important areas of resistance this rally may simply be an intermediate term Bear Market bounce. The rally has been suspect, in my eyes, due to too few solid growth names showing strong fundamental attributes - though we are seeing some improvement.

The Dow 1938 Rally

(Click image to view larger version)

Even if this is a Bear Market rally there could be additional price improvement into the summer. We also believe it is likely there will be a short term correction and consolidation. Why do we feel the market will not continue to advance straight up from here? Using historical precedence shown in the Dow chart above, the market corrected from it's 4-27-39 short term high, as bull markets will tend to do. It then consolidated its gains, pulling back 10% for five more weeks before advancing 36% in eight weeks from point C on the chart. This type of action would be entirely normal, healthy, and expected after this run. Using this scenario, one possible strategy may be to not get too fully committed at the current market level and let some correction emerge in the upcoming months to obtain better entry prices.

There are a lot of pundits saying the market is too "overbought" and to "sell in May and go away". We let our intermediate breadth indicators tell us when the rally is weakening and when to prepare for a correction. The market could surprise a lot of folks with a continued advance from here and it will be interesting to see what develops in the next few weeks.

We hope that some technical perspective is of value to our readers. Perhaps these technical concepts, using historical data points and charts, will seem similar to analyzing the condition of a patient under your care.

Have a great week!