Wednesday, August 01, 2007

Sharp Drops After Multi-Year Highs: What Comes Next?

We made all-time highs in the Dow Jones Industrial Average and multi-year highs in most major indexes, only to see a sharp decline over the following eight trading sessions. I decided to take a very long-term look at market history and see what has happened when the Dow has made a 1000 trading-session high, followed by an eight-day decline of 4% or more.

I went all the way back to 1909 (!) and found 53 such occurrences in 27,782 days of market data.

Sixty days following a sharp market drop from multi-year highs, the Dow was up by an average of 4.16% (39 up, 14 down). That is considerably stronger than the average 60-day gain of 1.59% for the remainder of the sample.

The occasions in recent market history include:

* Late Feb./Early March, 2007 - Up over 10% 60 days later.
* May, 2006 - Up modestly 60 days later after drawing down several further percent.
* January, 2000 - Down less than 2% 60 days later after drawing down over 10% further.
* September, 1999 - Up about 1% 60 days later after drawing down over 7% further.
* May, 1999 - Up over 4% 60 days later.
* July, 1998 - Down over 4% 60 days later after drawing down over 14%.
* August, 1997 - Down 3% 60 days later after being up over 3%.
* Feb., 1993 - Up over 4% 60 days later.
* April, 1991 - Up 3% 60 days later.
* Jan., 1990 - Up 1% 60 days later after drawing down over 4%.

Since 1990, when we've made multi-year highs and then dropped sharply, the market was higher 10 times and lower 5 times after 60 days for an average gain of 2.27%. Drawdowns, however, have been the norm: eleven of the fifteen occasions were down after 10 trading sessions.

Now here's an interesting finding: There were three periods in which the drop from multi-year highs turned into full-fledged bear moves (declines of more than 10%): Jan., 2000; July, 1998; and September, 1987. All three of those times, the market had moved sharply lower in the next ten trading sessions (over 1.5%) and continued lower thereafter.

Conversely, when the market was up 10 days following the sharp drop from multi-year highs (N = 27), it remained higher over the 60 day period 23 of those times. In fact, on 22 of those occasions, it added to its 10-day gains.

What that suggests is that a short, sharp drop from multi-year highs that stabilizes over the next two weeks tends to have a better trajectory than one that moves lower over the next two weeks. The short, sharp declines tend to be corrections in bull markets. It's when the short, sharp corrections don't find buyers swooping in to pick up values that the correction is most apt to become a bear.