NORMAL VOLATILITY HAS RETURNED! March 2, 2007.
In this column two weeks ago, I wondered how investors would react when normal volatility returns to the market after such a long period with no volatility at all. I noted that for three years the market had seen only 24 days when the Dow closed up or down more than 150 points. Yet over the previous five years there had been 245 days such days (as well as 122 days when it moved more than 200 points, 30 days when it moved more than 300 points, and even 8 days when the one-day moves exceeded 400 points).
Just two weeks later normal volatility has returned, beginning with that 415 point decline by the Dow on Tuesday. It created a bit of panic on the TV financial shows for awhile. Anchors were particularly frustrated when they couldn’t get instant and easy answers in interviews. One after another, analysts responded to their question, “What should investors expect now?” with the answer, “At this point I have no way of knowing. We’ll just have to wait and see how the market trades for the next few days.”
There was volatility during the trading day on Wednesday and Thursday, with the Dow swinging as much as 200 points between its low and high, but only fractional changes by the close each day. The Dow closed back up 52 points on Wednesday, and down only 34 points on Thursday. So by Friday morning bullishness had returned. Wall Street spokesmen were advising investors to take advantage of the bargain prices. One gentleman told CNBC viewers that the market had undergone a ‘bloody’ correction on Tuesday that had stocks on the bargain table.
Perhaps. But I doubt it. A 4% decline is a pullback, not a correction, and certainly not a ‘bloody’ correction. The term correction implies that a condition is being corrected. Sometimes it’s overvaluations. Sometimes it’s overbought conditions. Sometimes it’s investor sentiment that has become too euphoric. A 4% decline of a few days duration does not correct anything, which is why actual corrections, as opposed to brief pullbacks, just don’t end that quickly.
The market has been overdue for a correction of 10% or so on the Dow and S&P 500, and up to 20% on the more speculative Nasdaq for quite some time. After three years of such a non-volatile market, that may seem like a lot. But it is not. As I pointed out a few weeks ago, over the last 50 years the Dow has experienced a decline of 10% on average of every 1.4 years, whether in a bull or bear market. It happened even in the rip-roaring seemingly one-direction 1990s bull market. It has had a 15% decline on average of every 2.2 years, and a decline of more than 20% (a bear market) on average of every 3.8 years.
The Dow hit a new high of 12,786 on February 20. A 10% decline would be to 11,507. A 15% decline would be to 10,868. Either of those would be normal corrections, and would not be enough to break the uptrend of the bull market that began in 2002.
One reason I’ve been expecting such a correction, which if I am right, would mean this week’s decline has further to go, is technical. As I noted in this column a few weeks ago, the Dow and S&P 500 were over-extended above their 200-day moving averages to a degree that in the past always ended badly, usually so quickly that it leaves no time to exit undamaged. And once a correction begins from such an overbought condition it usually doesn’t end until the indexes have broken below their 200-day moving averages to an oversold condition. That usually takes four to six weeks, with brief rally attempts along the way. At this point, the indexes have a ways to go before they would even be down to the moving averages, let alone oversold beneath them. For instance, the Dow’ 200-day m.a. is at 11,775.
My other reason for believing the correction has further to go is based on investor sentiment. Investors are usually very bullish and euphoric at market tops, made so by the rising prices and profits. They expect any pullbacks to be brief, and to be buying opportunities. Conversely, sentiment is usually very bearish and pessimistic by the time corrections have run their course, with the consensus being that even lower prices lie ahead.
At this point there is some nervousness. The volatility certainly has investors’ attention. But there is no evidence that investors have lost their confidence in the bull market to any degree.
For these, and other reasons, and in spite of the bullish noises already coming out of Wall Street, I expect the correction has further to go. We will be providing subscribers with updates as additional data comes in.
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