As 2009 wraps up there have only only a handful of years that have exhibited similar characteristics to this year. The Dow lost just over 54% of its value from the October 2007 high to the March 2009 low. This has been followed by a 63% rally from the March low in just over 3 quarters.
Going back through the history of the Dow there have only been a few other occurrences when such a dramatic reversal has occurred over a relative short period of time and I will review a few of these cases that most resemble the current pattern.
Starting with the early 1900's there was a 49% drop from early 1906 through late 1907 which was then followed by a 61% rally over the next 3 quarters. In this example the Dow continued to move higher through the middle part of 1909 (point A) before peaking as it got close to its previous high made in 1906. However notice after peaking in the middle part of 1909 this was then followed by a substantial pullback through late 1914 (points A to B) in which the Dow lost nearly 46% and eventually retested the previous low made in late 1907.
Meanwhile the next period of time was in the late 1930's as the Dow lost 50% of its value from early 1937 through early 1938. This was then followed by a 63% rally over the next 3 quarters as the Dow peaked in late 1938. Meanwhile after peaking in late 1938 the Dow then pulled back over the next 3 1/2 years (points C to D) and eventually retested the previous low made in early 1938 as it lost 42% of its value.
The next similar period was in the mid 1970's as the Dow lost nearly 47% of its value from early 1973 through late 1974 which was then followed by a 55% rally over the next 3 quarters. This was then followed by a one quarter pullback of 12% before the Dow rallied again for a few more quarters before peaking in the middle part of 1976 (point E) as it gained a total of 80% from the late 1974 low. However notice after the Dow peaked in the middle part of 1976 that by the middle part of 1982 it was 25% lower (points E to F). Thus over the next 7 years the Dow did absolutely nothing as it got stuck in an extended trading range.
However when you factor in Inflation the chart looks a lot worse in terms of real dollars as the Dow was substantially lower by the middle part of 1982 as it was down nearly 57% from the mid 1976 peak.
As you can see based on past occurrences it's certainly not out of the question the Dow could even go higher in 2010 based on what happened in the early 1900's and in the mid 1970's. However remember that once all three of these impressive oversold rallies ended the next 3 to 7 years were followed by a 25% to 45% drop in the Dow with a retest of the prior lows in two out of the three cases.
Finally one of the things to watch as we move into 2010 are the Banks. The Banking Index (BKX) has been diverging from the S&P 500 the past few months as the S&P 500 has been moving higher while the BKX hasn't. There was a similar divergence in 2007 leading up to the peak in the S&P 500 during the Fall as the BKX topped out several weeks before the S&P 500. If the Banks come under renewed selling pressure in 2010 that will eventually spell trouble for the broader market as well.
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