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June 22, 2003
Dr. Brett Steenbarger: On Language and Counting

Here is a perfect post from the always erudite, young hearted and creative Dr. Brett that asks a proper testable question, puts it in the context of proper psychological denial, and then answers it as best it can. Amazing that so many can speculate about how certain bear market lows are typically followed by rises of x%, this one being not at all divergent and therefore bearish. The Brett approach is the essence of science and prospectivity; the Russellian, Prechterian, Abelsonian latter approach is the exact Gelleresque, retrospective, completely -consistent-with-randomness approach favored by the mistress. – Victor Niederhoffer

The language people use often covers their sentiment. Last week I had a resident therapist describe a patient as "someone who pushes people away". I pointed out that the patient did no such thing; that she had been abused as a child and protected herself by keeping others at a distance. "Now," I suggested, "Let's talk about how *you* feel pushed away." It was easier for the therapist to describe the client as manipulative and distancing than to face his own feelings of being rejected.

So it is in the market. The phrase I keep hearing is that "the market has gotten ahead of itself." It "has risen too far, too fast". It is "overbought". What I would say to the market analyst if he were my student is: "The market is rising in a normal fashion following a bear market low. Now, let's look at how the market has gotten ahead of *you*."

I doubt that those talking bearishly have been correctly positioned for this move. It is easier, however, to talk about the market's irrationality than to acknowledge their own timing shortfalls.

Now, does an exuberant market such as we've had typically turn around and head south?

It's a bit hard to put statistics on the table because, if my historical analysis is correct, we've only had four non-overlapping market periods when the S&P 500 has been up between 15-25% over the past 75 sessions, but relatively flat (between -5% and 5%) for the past 250 sessions. Note that this pattern captures a sharp rise after a prolonged decline.

The four periods I identified since 1966 were: 12/1970, 5/1975, 10/1982, and 2/1991. After the big rises over 75 sessions, the *next* 250 sessions were up 5.6%, 11.7%, 31.8%, and 18.2% respectively. Note that this period included the bearish 1966-1982 period as well as the bull period of 1982-2000.

Now maybe this time will be different, and we truly are in a 1930s scenario a la Prechter, etc. But maybe it's just easier to talk about broken clients and broken markets than to face one's own damage.

While an N of 4 is hardly a firm foundation for counting, the historical record does say that in the last 40 years, a market that rockets out of a long-term decline has gone higher over the next year, not lower. But how about sharp market rises of 75 days during flat periods of 250 days from 1929 to 1949? It turns out that this occurred on the Dow during 4/30, 1/35, 8/38, 9/39, and 6/48. Over the *next* 250 days, the market's returns were -41%, 33%, -2%, -19%, -10%. In other words, 4 out of 5 times, the market was *lower* after such a rise from 1929-1949.

It's a nice example of changing cycles. During the horrendous bear period, the sharp rise ("overbought market") became an opportunity to sell; during the great bull march, the sharp rise continued to move ahead a year later.

So that leaves us with the question: Is the present market more like 1929-1949 or 1966 to 2000? With the small Ns, formal statistical analysis is to little avail. While strength has tended to beget strength over the last 40 years, it's by no means a certain thing. Using the Dow rather than the SP, the market's most recent sharp rise after a protracted decline (75 days/250 days) occurred on 1/2002--and the market was lower by 16% after the next 250 days. That is the first time a sharp rise after a protracted decline has led to lower prices since 1948.
--Brett Steenbarger (6/22/2003)