Stocks on the edge of the abyss

A look at market history suggests trouble if stocks can't mount a quick rebound.

By Anthony Mirhaydari Jan 28, 2010 9:23PM

MirhaydariStocks are sitting smack in the middle of a very oversold condition based on technical and market breadth measures. A failure by the bulls to take advantage of the situation would be a clear warning that the balance of power has shifted and we should prepare for further declines. No matter what time of the year or what the price level of the major indices, this relationship holds true.

 

But there is more at stake at the moment, based on seasonality and price levels, which makes a big rebound more important than usual.

 

During last week's stock sell-off, the Dow industrials moved below theirDecember closing low of 10,285 (from Dec. 8), triggering what Jeff and Yale Hirsch -- the father-and-son team behind the Stock Trader's Almanac -- dub the "December Low Indicator." According to their analysis, since 1950 when the December Low Indicator was triggered, the Dow went on to lose another 10.9% on average. It happened in each of the last two years, with the Dow losing another 42% in 2008 and 17.6% in 2009.

 

Is 2010 fated to repeat these dismal performances? History suggests it can be avoided if stocks can manage a quick rebound rally by the end of the week. Here's why.

 

The first involves what the Hirsch duo call the "January Barometer." If the S&P 500 can climb another 1.7% by the end of trading on Friday, it would turn January's monthly return positive. In the 11 years when the December low was violated but the January Barometer was positive, subsequent declines were limited to 6%. Moreover, the overall annual performance for these years was much better, with an average gain of 8.2% compared to a 4% loss in the years that both indicators were negative.

 

Current 18-Week

 

Another reason involves the 18-week moving average on the S&P 500. I like using the 18-week average since it acts as an early warning device for significant changes in trend. For your benefit, I took a look at stock market data going all the way back to the late 1700s (thanks to the work of the folks at Global Financial Data). On average, it takes eight weeks to reverse a decline below this level. For perspective, the longest decline under the 18-week average lasted 42 weeks and ended last April.

 

If all goes well, stocks will blast higher and these worst-case scenarios won't matter; if they don't, we should prepare for more weakness over the coming months.

 

One last thing. The weekly analysis suggests the stock market is overdue for a meaningful correction: On average, a downward cross of the 18-week moving average occurs on average every 11.9 weeks since 1793. Right now, the S&P 500 has gone 43 weeks without a downward cross.

 

2003-2004

 

While this is extended, it isn't out of the ordinary for the early phases of a new bull market: The S&P 500 had three extended runs over its 18-week average in the 1950s of 50, 103 and 86 weeks in length. More recently, the S&P 500 went 51 weeks over its 18-week average in late 2003 and early 2004.

 

We're likely to see a short-term bounce off the 18-week average before the S&P 500 finally gives up the level and trends sideways for 10 months or so. After that, we should see another long run over the 18-week average as equities blast higher and bonds stumble as interest rates and inflation expectations creep higher.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned. You can watch him trade during the day at Wall Street Survivor here.

 

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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