Is the Dow's Two-Day Loss a Correction, or a Calamity?

|
 |  Includes: DIA, QQQ, SPY
by: Prieur du Plessis

“Down, down, deeper and down”. So goes the chorus of a Status Quo song, but it is eerily starting to sound like the stock market’s anthem.

When writing an article on Thursday’s 312 point drop in the Dow Jones Industrial Index, I did not quite contemplate market circumstances requiring a sequel so soon thereafter. But alas, Thursday’s sell-off deepened on Friday with a further 208 points being shaved off, resulting in a loss of 520 points (-3.8%) for the combined two trading days.

Equities (and other asset classes) were liquidated across the board as concerns about worsening credit conditions intensified, with only cash and bonds being accorded safe-haven status in an otherwise rough week. In addition, a rising yen has sent the carry traders dashing for cover.

The weekly decline of 4.2% was the worst since March 2003, resulting in the following rather unhealthy-looking chart. (Small caps fared significantly worse as indicated by the 7.0% decline in the Russell 2000 Index over the week.)

click to enlarge
SPX Chart
Source: StockCharts.com

How does the 520 point two-day decline rank when considering the Dow’s history?

Since its inception in 1886 the Dow has experienced 13 consecutive two trading days with declines of 519.6 points or more, i.e. 0.1% of the total number of two-day periods. However, as far as percentage declines are concerned, two-day declines of 3.8% or more are quite plentiful, and have occurred 474 times, which is 1.7% of the total.

But more importantly, this represents the single largest two-day decrease in points since the market bottom of October 9, 2002, and the subsequent relatively correction-free bull market. And, in percentage terms it ranks second only after the 4.5% drop on January 24 and 27, 2007.

This raises the question as to what typically happened in the past on the trading days immediately following significant two-day sell-offs. A cursory analysis would suggest a recovery in most instances, especially when disregarding September 11, 2001.

However, this offers little help in determining the intermediate trend for stock markets. In my opinion, key to the outlook for equities over the next few months is the reassessment of risk by investors, courtesy of the meltdown of the sub-prime mortgage market curtailing deal finance and removing a significant previous tailwind for equities.

One starts comprehending the sub-prime fall-out when looking at the horrific trend of the ABX Index, which represents a basket of credit default swaps on high-risk mortgages and home equity loans, and has lost almost 60% of its value since the beginning of the year. Some estimates put the quantum of the losses at as much as $100 billion. (Also see a discussion of this in business partner John Mauldin’s e-letter of July, 27 2007.)

ABX INDEX

click to enlarge
ABX Chart
Source: Markit

Let’s have another look at the weekly chart of the S&P 500 Index shown at the beginning of the article. One does not have to be a particularly astute technical analyst to identify the 40-week (200-day) moving average looking in danger of being broken, particularly when considering that a sell signal has just been given by the MACD oscillator.

An even more worrying graph is the NYSE Bullish Percent Index, indicating the percentage of stocks in uptrends. This graph is approaching the 50% level (i.e. half the stocks in downtrends), and looks decidedly bearish.

click to enlarge
NYSE Chart
Source: StockCharts.com

My take of the market situation is that in order to clear out excessive leverage, and over-speculation we will probably be faced with more than a routine pull-back, and that a further downside is in store (obviously not precluding short-term bounces from time to time). Although the magnitude of further stock market declines is difficult to gauge, it may take a while before investors’ appetite for risk is revived.

The ride may turn out to be quite uncomfortable …

click to enlarge
Cartoon
Source: Unknown