What Does A 490 Point Advance In The Dow Foretell?

 |  Includes: DIA
by: Thomas J. Feeney

After Wednesday, November 30th’s massive 490-point rally in the Dow Jones Industrial Average, USA Today ran a lead story highlighting the ten biggest point gains ever. The most recent advance was the seventh largest. All ten have occurred in the last ten years. While the USA Today story did not pretend to draw conclusions about future price movements, it clearly implied that such an advance was an indication of overdone fear in a context of many positive, underappreciated factors.

A quick look at the dates of the other nine biggest gains clarifies that most took place in major bear markets. Eight of the prior nine took place after major market declines yet well above ultimate bear market bottoms. Only the 497-point surge on March 23, 2009 occurred near the beginning of a new bull market. In that instance, stock prices had bottomed just two weeks earlier, and the advance proved to be part of the initial surge in a market rally that carried for 26 months. From the history of this century-to-date, therefore, the recent rise looks unlikely to mark the kickoff of an extended rally.

Leaning in a more bullish direction, however, is a study by Ned Davis Research, Inc., a highly reputable source of historical data. Their December 6 report revealed that since 1950, there have been 37 instances of a 4% or better one-day advance in the Dow Jones Industrial Average. In 33 of those instances, the market was higher 12 months later. Those advances included most of the big gains that took place during the two giant bear markets that opened the twenty-first century.

The Ned Davis data showed that over the six-decade period of their study, such 4% one-day surges have typically initiated advances that grew roughly another 20% -- more or less steadily over the subsequent 12 months. That behavior clearly differs from eight of the most recent nine advances in the last decade, which saw major declines to ultimate bear market bottoms before beginning lasting recoveries. Another important observation in the Ned Davis study was that preceding the 4% one-day surges, stock prices had on average been declining aggressively, by about 22% in the prior seven months and an even more aggressive 18% in the immediately prior three months. In other words, stocks typically surged out of a significantly oversold condition.

What do these seemingly conflicting data suggest for the aftermath of our most recent stock market surge? It is important to note that the November 30th rally did not flow from a seriously oversold condition. In fact, it began at a price level roughly 10% above where the index had traded about two and four months earlier. This is markedly different from the typical advance profiled in the Ned Davis study and all nine of the biggest point-gaining days of this century.

If I had to choose between the precedents offered by price patterns in this century and those from the last half of the prior century, I would lean toward the most recent experience. These observations took place in the era of egregiously overextended debt, which continues to provide the backdrop for today’s market. That, I suggest, is the single most critical variable weighing on economic progress and equity prices. If prices follow the recent precedent, they are likely to move significantly lower before beginning the next sustainable market advance.

While we are now in the seasonally strong month of December, interpretation of news from Europe will probably be the single biggest determinant of stock prices’ immediate path.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.