The UK stock market kicked off 2006 with a bang. Shares rose sharply on the year’s first two trading days. Many hope this positive start will continue. But history leads us to a different conclusion. Several long-running historical trends warn of possible disappointment just ahead.
One important trend worth thinking about is the behaviour of the world’s stock markets after a bubble bursts. History teaches that it is impossible to predict when an explosive rally like the one enjoyed in the late-1990s will end. However, the post-bubble aftermath is always the same. Prices always return to their long-term trend line. There has never been an exception to this reversal process no matter which index, which country or which century you turn to.
The chart of America’s Dow Jones Industrial Average illustrates the problem currently facing investors. The exact location of the Dow’s long-term trend line is subject to some debate. If you define “long-term” as the last 25 years, the solid red trend line currently sits in the mid-5000 area. If you base your analysis on all price swings since the second World War, the dotted red trend line is closer to 1000.
Either way, it is a chilling analysis. This reliable historical indicator suggests the Dow Jones Industrial Average is remarkably vulnerable to a serious fall in the years ahead.
Unfortunately, history does not help us to predict how long it will take for the correction to run its course. Some post-bubble reversals were fast and furious. America’s Nasdaq index fell by 75 per cent in just 24 months once the peak was reached in 2000.
Other corrections unfold in a more leisurely fashion. The Japanese stock market peaked in 1990 and then fell by 80 per cent over 14 years. Prices zigged and zagged along the way with some rallies running for as long as 18 months. But the long-term down trend never changed until prices fell to their long-term average.
A third possibility is for shares to drift sideways for many years or decades. Along the way, some fast-moving investors will enjoy occasional profitable rallies. But these rallies will prove to be unsustainable. Eventually, the current price and the long-term average will intersect.
We do not know how the current imbalance will work its way out. All history can tell us with certainty is that shares are vulnerable. With luck, Wall Street will follow the sideways path rather than falling steeply.
A second historical trend worth thinking about focuses on the behaviour of shares in the aftermath of very painful shorter-term downturns like the one that slammed us in 2000 to March 2003.
History teaches that recovery rallies generally run for a limited period of time once a steep downturn finally ends. It is very rare for such bounce-back rallies to run longer than 30 months. It is an important point because London began to rally in March 2003, 34 months ago. Wall Street has been rallying since October 2002, 39 months ago. We covered this ground in some detail a few months ago. You can review the complete article by clicking on Expert Commentary / David Schwartz / Archive in the panel to the left of this column.
Trends like this do not precisely tell us when the next fall will begin but make the clear point that the stock market is quite vulnerable.
As far as current stock market conditions are concerned, optimists hope us this time will be different. The US economy, the world’s growth engine, is growing nicely. There is no sign of inflation. A watchful Federal Reserve has learned valuable lessons from past errors and will insure steady future growth.
This argument ignores a key point. Optimists forget the stock market is forward-looking. The positive economic conditions that lie just ahead help to explain why shares reached current levels. But they do not explain how prices will remain at current levels. As City pundits often say, the good news is in the price.
This backdrop helps to explain why shares on both sides of the Atlantic are not likely to rise in 2006 for the fourth year in a row.
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Book Review by David Schwartz - 'New Market Mavericks'
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