Knockout Punch for the Stock Markets?

Boxers are tough. So are secular bear markets. Whether or not we have been in one since back in 2000 (we say yes) is a subject of constant debate in the investment advisory industry. What is more important to investors today is whether past market behavior tells us anything important about the current environment? We think the answer is yes - human behavior repeats itself over and over again. This happens in life, and certainly in the way investment markets behave at times. So, with that preamble out of the way, let’s focus on one historical pattern we identified some time ago which is playing out in a rather interesting way…interesting, as in bad, that is.

We see many parallels the price trends in the Dow Jones Industrial Average between the period from 1961 through the mid-1970s and the current market environment, which we think is part of a longer market pattern dating back to the popping of the tech bubble in early 2000. The chart shown here is very detailed, so here is a written explanation to guide you through it:

In both 1961 and 2000, it can be argued that long-term period of sluggish stock prices, containing both boom and bust periods, started. The initial decline severe (a 27% drop in the 1960s and a gaudy 37% from 2000 – 2002 was followed by a rally that came close to a doubling in prices in a period well under a decade.

A “second leg down” followed. 2008-2009′s bottom was the weaker of the two time periods, with a 54% drop as compared to 36% in 1970. In each time period, what followed next was a second strong rally, lasting for years and producing a sizable gain (67% in the early 1970s and 153% in the past five years ending in 2013).

It is what happened next that spurred us to look closely at the two time periods. In each case, the market blew through its previous historical high, fooling some into thinking that a new bull market had begun. In 1973, the new high was 7% above the previous one from back in 1966. But last year, the Dow ended a whopping 17% above the previous high mark from back in 2008! Is it a new bull market?

We think not. The reasons why are numerous, but they tend to point to the absurd amount of economic protection promoted by the Federal Reserve Board and other central banks around the world. That same world is just now coming to grips with the consequences of those policies.

How far could it drop? If the historical pattern continues, it could be a disruptive force. If we apply the same 45% decline to the current market that investors experienced back in the early 1970s, the Dow ends up at…cover your ears…9117. Is that Sungarden’s forecast? NO! We are simply pointing out that severe situations are on the table, and that investors and their financial advisors should be planning for the possibility that what goes up must go down…and sometimes very hard.

The silver lining? Back in the 1970s, that dive lower in ’74, was followed by a strong rally that saw the Dow land about where it had been a few years earlier. Now, some investors will claim that they can deal with big declines because “it always comes back.” That type of thinking is prevalent in times like these, when large declines in stock prices are a distant memory to some.

We don’t know where the market is going, and frankly our mission does not change regardless of what happens. It is still about having an investment process that prioritizes volatility management (commensurate with each client’s willingness to take on price swings) seeking profits as the environment allows (and it will again), and doing all we can to avoid major losses in value. The ante has been raised in recent days such that the potential for major loss is at least entering the conversation.

From a long-term perspective, we have seen a 14-year period in which the Dow has fallen hard twice, only to get up off the proverbial canvas both times. Just in case the market is winding up to deliver the knockout blow (a third major decline since 2000) to overconfident or complacent investors and financial advisors, it is best to make sure your mouth guard is in place and the smelling salts are close by.

Picture for Boxing Blog Post

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