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If it is in fact true that “past is prologue” then what I am about to show you suggests that it may be at least a few more years before the stock market gets back into a truly bullish mode. OK, that sounds a little depressing. Even perhaps a bit alarmist given the strong rally that the stock market has experienced since March of this year. But to start to make the case, consider the two stock market index equity curves that appear in Chart 1. A very quick glance might leave you with the impression that the top and bottom clips contain the same chart. Even a slightly longer perusal might still leave you thinking that this must be two separate indexes plotted during the same timeframe. But as you will see in a moment, that is hardly the case. This is also what makes this comparison so chilling.

The top plot in Chart 1 is the performance of the Dow Jones Industrials Average from January of 1924 through December 31st of 1938. You can clearly see the broad rally of the Roaring '20s, the stock market collapse of 1929 into the 1930s, then a subsequent bounce followed by the grinding path to the final low in 1942.

So what is the bottom plot in Chart 1? This clip displays the performance of the Nasdaq Composite Index ($COMPQ) from July of 1994 into July of 2009. Surprised?

 

Chart 1 – Dow Industrials (1924-1938) versus OTC Composite (1994 to present)
click here for larger view

The similarity in the performance of these two indexes is nothing short of stunning. One obvious question here is, “how does this happen?” The truthful answer is that there is no real definitive way to explain these parallels.

The only thing we can say for sure is that for the past 15 years the fluctuations in the Nasdaq Composite Index have tracked with the performance of the Dow Jones Industrials Average between 1924 and 1938 with a stunningly high degree of correlation. The one thing we cannot say for sure is that this similarity will continue into the future. Nevertheless, even people who don’t believe in such things might be interested to know what will happen to the Nasdaq moving forward if it continues to follow the lead of the Dow from seven decades ago.

Although, be forewarned. It isn’t pretty.

Chart 2 extends the top clip (of the Dow) from Chart 1 from the end of 1938 to the end of 1944. As you can see, while the stock market staged several rallies along the way, the overall action was mostly a grinding affair, with the final bear market low eventually being reached in April of 1942, 40% below its level at the end of 1938.

 

Chart 2 – Dow Performance 1924-1944

So what would this mean for the Nasdaq moving forward? If past is indeed prologue, then if this parallel performance continues, the Nasdaq will finally bottom out around October of 2012 at a level more than 40% below today’s price level. This is not a future that most investors would care to see unfold, but if it were to happen here is what it would look like: 

2009-2010: 
*The OTC would trend lower throughout the rest of 2009, reaching a low around 1400 in early to mid-October.

*From there it would bounce back up into the mid-1700 range by April of 2010.

*Then the OTC would chop sideways to slightly lower for most of 2010 before once again plunging sharply during the October into December 2010 timeframe.

2011-2012:
*After mostly drifting sideways to lower from 2009 through 2011, the stock market (again assuming the Nasdaq follows the Dow 1924-1944 analog) would reward investor’s patience in 2012 – by finally plunging to a final low.

*If past is prologue the Nasdaq would peak in early January of 2012 and then drop roughly 30% from there by the end of October 2012.

Late 2012 and beyond:
*After the late 2012 low is finally reached the stock market will finally end a twelve-year bear market and embark on a new uptrend, advancing over 60% by July of 2015.

All in all, the scenario just described is not a happy prospect. So will the OTC Composite really be 40% below its current level three-plus years from now? We hope not, but in the end only time will tell. In any event, the real point is that you need to be aware of the potential for a great deal more downside and to make plans to do something other that simply “riding it down” if in fact an even longer, more drawn out bear market ensues.

Summary

The prospect of waiting around another three years for the stock market to finally “get going again” is not something that the majority of investors are prepared to do. Anyone who cut his or her teeth in the financial markets during the bull market of the 1990s is still trying to figure out what went wrong on their way to untold wealth and is getting impatient waiting for things to “get back to the way they were.” 

Of course “what went wrong” is that the stock market moves in waves – the same as it ever was. Sometimes the waves are up and sometimes not. Investors have become conditioned over the course of the past several decades to think that the stock market “always moves higher." And in the macro sense this is essentially true. But the pauses can be long drawn out affairs.

Remember that after the Dow topped out in 1929 it did not make a new all-time high until 1954. Likewise, the Dow gained no new ground from 1966 to 1982. So if by chance the present bear market does in fact not ultimately bottom out until 2012, one could argue that we will actually be getting off easy by comparisons sake.

The Dow/OTC analog that we have highlighted should not be viewed as a prediction. No one has a crystal ball. And while the Dow/Nasdaq analog we have highlighted has been uncannily accurate over the last 15 years, it would be unwise to base all of one’s futures investment decisions on something quite so esoteric. As long as the stock market keeps trending higher, all is well. But if the market starts to roll over – for example, if the Dow, Nasdaq, S&P 500 and Russell 2000 start seeing their respective 10-day moving averages drop below their respective 30-day moving averages – you might be wise to take some defensive action rather than simply sitting there and “hoping that the market comes back.”

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTES: 

To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.

To sign up for a free 1-month trial of Optionetics ETF Investor newsletter, edited by Jay Kaeppel and Clare White, you can do so by clicking here. 

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Recent Articles by Jay Kaeppel, Optionetics.com

• July 22, 2009
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