Stock market averages posted incredible performances in the week ending March 13. The S&P 500 and Nasdaq Composite Index both gained approximately 11 percent after reaching multi-year lows on Monday of that week.
The S&P 500 had destroyed 12 years’ worth of gains at its lowest point. The Nasdaq traded at a six-year low and about 75 percent below its all-time high, reached almost nine years ago.
The old-economy Dow Jones Industrial Average rose 9 percent for the week. The biggest gainer of the week was the Russell 2000 Index of small companies, which increased 12 percent.
Optimism has rapidly replaced pessimism on CNBC and on many financial web sites. Investors are notoriously fickle and anxiously look for signs of a market bottom, with many believing that such large gains over such a short time are unprecedented.
After such a big move, the logical question to ask is, “Has a new bull market started?”
Remember the “dead cat bounce.” Traders spend a lot of time on the exchange floor and to pass the hours, at times, they can come up with unique descriptions of market action. Often the type of rally we just experienced is called a “dead cat bounce.”
This colorful phrase describes the hopefully untested belief that even a dead cat will bounce if it is dropped from a high enough level.
Since the start of the year, the stock market has certainly experienced a sudden drop from what was a higher level of prices. After falling so hard, it was due for a bounce. But it will take an improving economy to make that bounce into anything more than a short rally.
History tells us that we should remain cautious. The Dow has risen by at least 9 percent in a week 19 times since 1920. The week after that rise, the index was higher less than half of the time, and a month later the Dow was able to add to its big gains just over half the time.
In fact, the Dow normally increases over a week’s time. It shows a weekly gain 53 percent of the time and a monthly gain 58 percent of the time. The average market performance after a big gain like we just saw is actually lower than average.
Other indexes, such as the S&P 500 or the Nasdaq Composite, show the same historical pattern. We use the Dow for testing here because it has the longest history.
Prior to last week’s rally, the market had become deeply oversold. Technicians look for a relief rally after such a prolonged period of selling.
One reason for this is that short sellers are sitting on large profits and get nervous at the first sign of a rally. Taking their profits requires them to buy the stocks they are short.
The initial buying can drive prices higher and convince other shorts to cover their trades. In the end, the market goes up, but this is not the basis of a sustainable bull market.
Traders know that only fools try to pick bottoms and tops. There is a lot of money to be made by catching the middle of the trend. The smart money, though, is waiting on the sidelines for the market to prove itself. There will still be plenty of rewards available to the cautious if this is really a new bull market.
Cautious investors should be waiting for the averages to break above their long-term moving averages before buying stocks. Aggressive traders can buy at current levels but have tight stops in place in case things go wrong.
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