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Bear-market corrections

Created:
6 May 2008
Written by:
Marc Rivalland

Three weeks ago, at least two noted American commentators boldly announced that the market's troubles were effectively over and that the Dow Jones Industrial average is heading for 16000. It started me thinking about how bear-market corrections differ from bull-market corrections. Every bull market has a Dow-theory secondary correction at some point. It is in the nature of a bull market to climb a wall of worry. Every now and then the worry gets the better of it for a while. But the bull market resumes. New highs are made. But why should the same be true of a bear market? We already know that prices decline about twice as fast as they rise. We also know that the market is a highly efficient discounting mechanism. Unless the bear market has two distinct stages to it with the second stage somehow unanticipated by the market, I don't see the necessity for a full-blown Dow-theory bear-market correction.

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It is a widely held view that after the market has finished with the current short-term up-trend, it is highly likely to plunge to new lows for the year. Need it be so? I examined the 1974 bear market. The FT 30 peaked in August 1972. There was just one correction in mid-1973 that might have qualified as a Dow-theory correction when the market rallied 13 per cent in three months. But there were no relevant corrections thereafter as the market more than halved in value between mid-1973 and April 1974 when it made its low, down 72 per cent from the peak. It then went up 156 per cent until July 1975. It had regained just over two-thirds of its losses. It then fell for the rest of 1975 by a hefty 35 per cent, before it doubled in 1976. And you thought modern times were volatile! Once the lows had been made, they were not really re-tested. The idea that the bull market started only when the highs of the mid-1973 correction were breached is utterly fanciful. Dow-theory was excellent in identifying the bear market, but not the ensuing bull market. Once the lows were in place, the bears were taken to the cleaners.

When I look at the Nasdaq chart, with its nicely rounded lows, it strikes me that we may not see prices below 1700 again. Then I factor in a comment from the US that 70 per cent of the US tech companies that have reported earnings so far have beaten estimates. Analysts see double-digit earnings for the rest of this year in the tech sector.

It does seem likely that the bears are going to have another crack at the downside. And since the banking sector is such an important part of the UK market, which doesn’t really have a tech sector to hold it up, FTSE 100 may well make new lows in the summer. But I don't think the same is true of the Nasdaq or the S&P 500. Classic Dow-theory attaches a lot of weight to the market's failure to make a new high or low after a correction, so it is by no means an unusual idea.

To be clear: I don't rule out new lows in the US markets. An "unknown unknown" could certainly upset the Nasdaq chart, but I shall be budgeting for a higher low until strong new evidence presents itself. I shall be approaching trading on the basis that there is a good chance that the bear market lows are in place in the US.

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