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Well it finally happened. After almost ten months of relatively smooth sailing, the stock market hit an air pocket last week and plunged over 4% for the week. If you want to know the standard reasons offered as to why this happened, please pick up any newspaper (and maybe hold onto it, it might be worth something someday) or visit any news related website. No need to waste time here spelling them out. Especially since in the end the "reasons" are unimportant. The only thing that matters from the perspective of a trader or investor is "what happens from here."

Too many people assume the simplified notion that "something happens" and then the stock market reacts, and then that "something else happens" and the stock market reacts to that, and so on and so forth. In reality, the stock market is a "discounting mechanism" that reacts more to perceived future trends - i.e., is the economy and corporate profitability likely to be weaker or stronger six to eighteen months from now. News events of the day essentially just give the pundits and "talking heads" something to use to fill their allotted time and space in "explaining" away the latest twist and turn in the market.

When the stock market is going up the news tends to be sweetness and light with a few stern prognosticators continually warning that "the end is near." And then when the masses are nice and comfortable and complacent and not paying so much attention to their stock market investments because "an uptrend is firmly in place," then, well, the stock markets seems to say, "Oh yeah? Watch this." And then the great debate arises as to whether the latest downdraft is a correction or the beginning of a bearish down leg. And in the end the ultimate answer is always the same: "time will tell."

So Now What?

So then, still we can't help but be curious as to how this latest pullback is likely to play out. As I detailed in my 1/6/2010 article, "Paranoidal Activity"

http://www.optionetics.com/market/articles/22171

a person can look at a chart of the Dow and choose to see, either:

• A market in a firmly established uptrend, or;
• A market that has retraced a significant portion of its previous decline and which may now be ready to embark on another major down leg.

Not an entirely helpful analysis. So let's look at it another way. First, a few generalities to help us narrow things down a bit:

• In an uptrend, the stock market tends to go "up" (OK, yes that was definitely pretty general), in a downtrend, the stock market tends to go - say it with me - "down."
• Pullbacks in uptrends tend to be buying opportunities as they are generally followed (eventually) by a resumption of the major uptrend.
• Rallies in downtrends tend to be selling opportunities as they are generally followed by a resumption of the major downtrend.

Alright, now I will grant you that we are not exactly engaging in rocket science here, but the good news is that rocket science is not required - just a little common sense and an ability to understand a bit of history. So let's consider a particular scenario. We will refer to the setup that I am about to describe as a JK Pullback (the use of my initials is done here because that is for some inexplicable reason simply what we analyst types tend do in order to delude ourselves into thinking that someone else will think that we invented it. Granted this has never worked for me in the past, but I am -alas - a Cubs fan - so there is always "next time.")

In any event, a JK Pullback is defined as follows:

• The Dow closes above its 100-day exponential moving average.
• The Dow has closed lower each of the last three trading days.
• At least one of the last three trading days has experienced a decline of -1.5% or more.

That's it. To spell it out a little more clearly, all that this describes is a situation whereby:

• The stock market can roughly be defined as in an "uptrend" (by virtue of the fact that the Dow is above its 100-day moving average);
• The market has experienced a pullback (three down closes in a row), and;
• There may be at least a hint of "fear" (at least one of the down days experienced a decline of at least 1.5%, a threshold that tends to get people's attention).

So the question, then, is, "What has the Dow done following this scenario?" For our purposes, we will start our test on December 31st, 1976. We will also look at how the Dow performed 1, 2, 3, 4, 5, 10, 15, 21 and 63 days after such occurrences, with a focus on 10-day performance.

In Figure 1 you can see the growth of $1,000 invested in the Dow only for a given number of days following each JK Pullback since 1976. The primary thing to note is that in the long run, each time period showed a gain. In other words, had you bought and held the Dow for 1 to 63 days following each JK Pullback since 1976 you would have made money. This speaks to the general reliability of the approach.

 

Figure 1 - Growth of $1,000 invested in the Dow for x-days following each JK Pullback since 1976

Now let's look specifically at the 10-day holding period. From here on, all results assume that the Dow is bought and held for 10 days after each JK Pullback.

In Figure 2 you see the growth of $1,000 invested in the Dow for 10 trading days after each JK Pullback signal.

 

Figure 2 - Growth of $1,000 invested in Dow for 10 trading days following each JK Pullback since 1976

Figure 3 displays some performance figures using this method versus the overall action of the stock market.

Figure 3 - Dow Performance following JK Pullback versus all Trading Days since 1976

The items to note are that:

• The 10 days following a JK Pullback tend to gain almost 6.4 times as much as the average 10-day gain for all trading days since 1976 (+0.0219/+0.0034).
• A little over 2/3's of JK Pullbacks have registered a gain 10 days later (67.5%).
• Also, the biggest drawdown in the equity curve that appears in Figure 2 was only about -6.6%.

SUMMARY

So in a nutshell, there is (as there always seems to be when it comes to the financial markets) some good news and some bad news. The good news is that the stock market shows a definite long-term tendency to rally following a well-defined pullback in an objectively identified uptrend. The bad news is that there is no guarantee that this pullback will be one of those times. So once again, it comes down to a question of discipline. If you are going to attempt to buy on pullbacks, you must resolve to do so each and every time your capital allows. The mistake to avoid is in picking and choosing which pullbacks you will buy and which ones you won't.

Murphy's Law pretty much insures how that strategy will work out.

UPDATES ON PREVIOUS TOPICS

Update #1: The JayNewary Barometer

Last week in my article "The JayNewary Barometer Revisited,"

http://www.optionetics.com/market/articles/22225

I wrote about what looked at the time like a sure thing to flash an important buy signal for the rest of the year. After last week's sell-off, the outlook goes like this:

• If the Dow Jones Industrials Average shows a net gain for this week, then the Barometer will reach the bullish +2 level.
• If the Dow gains this week and also closes the month of January above 10.428.05, the Barometer will reach its most bullish reading of +3.
• Over 90% of all +2 or +3 readings have been followed by an advance for the Dow between the end of January and the end of the following December. So this will be an interesting week.

Update #2: Large-Cap versus Small-Cap

In my 12/2/2009 article, "Large Cap v. Small Cap, Part I"

http://www.optionetics.com/market/articles/22067

I wrote about the historical tendency for small-cap stocks to outperform large-caps between the middle of December and the end of February. So far, between December 15th, 2009 and January 22nd, 2010:

• The Russell 2000 small-cap index (RUT) is up +1.8% while;
• The Russell 1000 large-cap index (RUI) is down -1.2%.

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.

NOTE:
Jay's latest book, Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, was ranked among the Top 10 Investment Books for 2009 by the venerable The Stock Trader's Almanac 2010. For more info, please click here.

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