I have had something of a common theme running through my articles of late. That theme is that the great bull market born in the 1980s is quite possibly finished and that an entire generation of investors who have become conditioned to believe that the stock market “always goes up” will either have to learn some ”new tricks” or remain a captive to the fluctuations of the stock market. In short, it's ultimately a gut-wrenching choice anyway you slice it. On the one hand, if you choose to change your approach in 2009 and to learn methods that can allow you to make money even if the stock market is not going up, you will be spending some time doing some work in order to get educated. You will also be forced to exit the “comfort zone” whereby you just put your money into the stock market and then blame someone else for your decreasing wealth if the stock market goes down. Or of course, you can simply remain ensconced in the “comfort zone” and “hope” for the best. Happy New Year!

The Present Conundrum

At this point, millions of investors are sitting tight with a vastly reduced portfolio of stocks and/or mutual funds and basically “hoping” that the worst is over and that January 20^th, 2009 will mark the “beginning of a new era” where everything is suddenly transformed into something better. And not wishing to be of the pessimistic sort, let me offer that perhaps they are right. But reality is at times a cruel thing. So rather than “hoping,” investors should be “preparing” for whatever eventuality may come our way.

Currently, investors who “rode the market down” are loath to sell. And this is perfectly understandable. The market appears to be attempting to form some sort of head-and-shoulders bottom formation, and a simple reflex rally that retraced 40 to 50% of the decline from the top would equal somewhere in the range of a 25% to 35% rally from present levels. And certainly people would feel a whole lot better after making back some of their losses, and even more to the point, would severely kick themselves if they sold now and missed “the rebound.”  But there are a few other dangers that need to be addressed.

The Dangers that Lurk

First off, a strong rebound in the market that retraces a portion of the recent bear market decline, would cause a great many investors to breathe a “sigh of relief” and to assume that things are “back to normal.”  And - as you will see in a moment - therein lies one of the most serious dangers facing investors today. I am also hopeful that the stock market will advance sharply from present levels. However, if that should happen, depending on the indicators and methods that I follow, I would anticipate advising investors to sell into that rally and to adopt a new approach to investing beyond the all too well ingrained buy-and-hold mentality.

Still, at this point, apparently there should be some concern as to whether or not we will even see a meaningful rally in the near-term. In this week's “The Trader” section of Barron’s Financial Weekly, Vito Racanelli highlighted a very interesting piece of research from a gentleman named John Harris, a market historian and professor emeritus of accounting at the University of Tulsa. In a piece of very insightful work, Mr. Harris examined nine previous years during which the S&P 500 lost at least -8% during the fourth quarter of the year. What he found was that the action in the subsequent year typically was not very pretty. In almost all cases, the market did not bottom out until it first plunged to sharply lower levels. Strike that. In almost all cases, the stock market first advanced early in the subsequent year and then plunged to a sharply lower low. The results based on John Harris’s work are presented below in Table 1.

Big “Down” Fourth Quarters

A few points regarding the results shown in Table 1:

• I used the perfomance of the Dow Jones Industrials Average in the following year rather than the S&P 500. As a result a couple of the dates are different than if one used the S&P 500 and the Dow and S&P vary in performance by a few percentage points here and there, but the results are in the same order of magnitude regardless.
• I also added a few columns to show the best gain achieved in the year following an 8% down fourth quarter prior to the (typical) plunge to the new low.

To understand the results in Table 1, consider the first line.

Columns 1 and 2: During the fourth quarter of 1929, the S&P 500 lost -28.9%.

Columns 3 and 4: Between 12/31/1929 and 4/17/1930 the Dow Jones Industrial Average gained +18.1%.

Columns 5 and 6: From the high established on the date shown in Column 3, the Dow plunged -46.4%, reaching a low on 12/16/1930.

Column 7: This left the Dow with a net loss of -36.6% between 12/31/1929 and 12/16/1930.

Table 1 - Results based on John Harris’ research on Down 4^th Quarters

As you can see in Table 1, in all but one case (1987-1988), the Dow declined double-digit percentage points within the year following a fourth quarter with a loss of 8% or more. The December 31^st to next year’s low decline was roughly -28%. A decline of that magnitude from current levels would put the Dow somewhere in the vicinity of 6,300. Not a prospect too many people want to think about at the moment.

As you can also see, in all cases there was some advance early in the year prior to the decline to the ultimate low. For example, in 2001 the Dow advanced +5.1% between 12/31/2000 and 5/21/2001. From there it dropped in excess of -27% before finally bottoming out in September of 2001. Hence the reason why I strongly advise investors not to “breathe a sigh of relief” if the market advances early in 2009. In fact, the research appearing in Table 1 suggests that the stronger an early 2009 rally might be, the more it should be viewed with skepticism. But human nature being what it is, I can assure you that the vast majority of investors would view a post inaugaration rally as an “all clear” signal.  

Summary

So are we destined to witness still further sharply lower lows? Not necessarily. I’ve watched so many indicators and reliable seasonal trends not work very well in the most recent fortnight that I simply think one has to be ready for anything. A large number of oversold indicators that I follow have been and remain at extremely oversold levels, suggesting that a sharp advance should be in the offing. Still, the figures in Table 1 strongly suggest that investors should not breathe that sigh of relief if the stock market does in fact rally early in the new year. Rather they should be thankful for an opportunity to exit at higher levels and then either raise some cash or at the very least set some trailing stops.

In the meantime, I suggest that you learn about option strategies such as collars, butterfly spreads and credit spreads, as well as more about gold stocks, Treasury Inflation Protected Bonds [TIPS], inverse exchange-traded funds, and so on and so forth (see Jeff Neal's Outside the Box: Using Government Backed TIPS to Insulate a Portfolio, 11/25/08). As you ponder New Year’s Resolutions (mine is to eat even more chocolate, because, well, what the heck!) this should be a priority for anyone who wishes to avoid having the markets decide their financial fates for them.

Yes indeed, brave new worlds appear to await in 2009. Start preparing for them now… and avoid the rush later.

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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site