Room to Fall: 110 Year Perspective for the Dow Jones Industrial Average

The S&P500 slipped almost 0.8% last week, on lower volume.  But since the week was holiday shortened, the decline in volume does not take diminish the importance of the price drop.  The VIX (or fear) index, interestingly, spiked up almost 20%, supporting the argument that more downside price risk may lie ahead.

 The week’s economic data were mixed.  The Empire State Manufacturing survey was weaker than expected.  Housing starts missed to the downside.  Existing home sales were slightly better than expected, but they were still down vs. last year and the median home price continued to decline.  Initial jobless claims were better than expected, but once again, the unadjusted figures were far worse than the headline claims number.  Leading economic indicators were stronger than the consensus forecast, while the Philly Fed survey came in below expectations.

Technically, the stock market is near the top of a long-term rising wedge pattern that began to form in the summer of 2010.  And it’s showing signs of pushing away from the top of the wedge.  The momentum and oscillator divergences are growing stronger and therefore point to a stronger correction when it finally arrives.  As far as the possible timeframes for this correction, the analysis is fairly straightforward.  Before QE2 winds down in a few months (and almost half of the $600 billion has already been pumped into the markets), any correction would have to overcome the strong forces created by the Fed.  It’s possible, but they would have to overwhelm the Fed’s powerful money printing machine.  But by the end of spring, markets will anticipate the wind down of QE2, and should start to sell off meaningfully.

Longer term, however, it’s useful to think about where the US stock markets could be headed by looking back in history.  And the longer one looks back, the better one can assess the range of possible outcomes.

The blog Risk Averse Alert focuses on almost exclusively on technical analysis, and has put together an interesting chart of the Dow Jones Industrial Average from 1900 to the present. 

There are two very important takeaways from the enclosed chart (using a log scale for price) and the trendline analysis provided by Risk Averse Alert.

First, note that the Dow Jones has shot way to the top of its 110 year old channel and well above its 75 year old (from 1935 through today) channel.  Applying the principal of mean reversion, one can easily argue that the price could drop down to about 3,600 before touching the bottom of the 75 year old channel.  Even more scary is the fact that the Dow could drop well below 2,000 before touching the bottom of its 110 year old channel.

Second,  in both cases, the UP trend line would NOT be broken.  Think about that.  The Dow could fall over 70% and STILL be in an uptrend that’s 75 years old.  It could fall about 85% and STILL be in an uptrend that’s 110 years old.  

This is what’s really scary about today’s valuations.  The stock markets are SO overvalued, that it would take a drop of over 90% to break a 110 year old UP trend line!

And most of the experts, today, don’t foresee a drop of even 10%. 

I’ll take the over.

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