October 24th, 2008

Lessons From Past Crashes and Recoveries Out of Them

While no two Bear Markets are exactly the same, the ebbs and flows of investor psychology seems to be fairly consistent and reliable, sort of like a pendulum swinging back and forth. The higher you swing the pendulum one way, the farther it swings in the opposite direction. Something else you can count on is that the herd usually takes three lurches followed by a clear and noticeable pause (recovery) as it pushes through a Bear Market. I know it sounds overly simplistic but that’s what history teaches. Let’s take a look at two powerful previous Bear Markets (click on graph to enlarge):

  • 2000-2003 Tech Bubble Crash: The way down consisted of three 3 steps of 20-plus % moves down each followed by a 20-plus % move up (remember that it takes a large percentage move up to negate the same percentage move down). The crash ended with the market fluctuating around 20% up and down for nine months. Note: I marked when the MTI gave it’s “red light” and “all-clear signals.

  • 1973-74 Oil Embargo Crises Crash: That Bear Market also featured 3 legs down with the final of nearly 40% representing the largest portion. What is most interesting is that the bounces after each leg down were “proportional” to the depth of the decline (remember to pendulum analogy). So while the bounces of the first three legs were around 13% each, the bounce following the big third leg was 27%. The crash ended with a quick (5-month) double out of which the market boomed ahead 47% before the first significant correction.

  • And what about this, the 2008 Credit Crises Bear Market Crash? This crash is eerily similar to the Oil Embargo Crash of 1973-74 (I’m sorry, I don’t want to tap myself on the back but take a look at the March 1 post, “1973 and 2001 Market Crashes and Today’s S&P 500 Index” in which I wrote:

“I hope not sounding like a scaremonger but need to point out that a look at comparable charts of the 1974 and 2001 peaks are instructive for seeing what can happen when downside momentum grabs hold of market players. The 1973-4 market crash mirrors many of the same forces that are at work today (escalating gas prices, inflation, weak dollar, weak President … staglation)….Of course, no one can predict the future and I’m not trying to do that here. What I am saying is that previous occurences of this crossover were precursors of further adverse momentum and market deterioration. Contrary to what the TV talking heads tell you, it’s no time to be buying on the dips! On the contrary, when the crossover does occur it’s time to buy puts on the market and load up on Ultrashort ETFs.”

(Unfortunately, I didn’t take my advice and didn’t load up on Ultrashort ETFs and what ETFs I did buy I sold too short.) Looking back on this crash predicted in March, we can now see three legs down with the fourth also being the largest (36% so far).

Will we see a double bottom this time, too? Will we see a nearly 50% bounce when an actual bottom pattern is completed and tested? No one knows but the 1972-74 model has worked so far so I’m structuring my strategy on it going forward. As Art Cashin, a favorite CNBC “talking head” and the long-experienced Dir. of Floor Operations for UBS, has been saying over the past couple of days, “After the capitulation ends, be prepared for a jaw-dropping recovery”.

Subscribe below or click here to learn more about help for navigating turbulent markets.