On this day in history. On October 19, 1987 the Dow Jones Industrial Average fell 508 points, or -22.6%. While the Dow had fallen already for several days prior to the day of the crash in 1987, this year the Dow has risen about every day in the past couple weeks. For market historians and investors who like to trade based on historical dates (we saw this for 9/11 for a couples years in the 2000s), today will have particular meaning.
Yesterday the Dow gapped higher after its long run up since last November. We have several observations.
1.) A gap higher after a long upward movement, with an index in over-bought conditions, risks to turn into an exhaustion gap.
2.) The 150 point gain in the Dow yesterday was fueled by IBM, one of the Dogs of the Dow. When a rally starts sucking money into the loser stocks, this is a warning sign.
3.) The rally in the Dow is feeling like a buying climax. People are willing to buy any index stocks at whatever price.
We compare the selling climax in early 2009 in the Dow with todays buy-at-any price rally. The key similarity is that, like in 2009 when people just wanted to get out of stocks and price did not matter, today buyers just want to get into stocks and the price level doesnt matter. The chart below takes the Dow Jones Industrial Average between 2007 and 2009 and inverts the scale. The Dow price chart over the past year is superimposed on the chart.
The blue line shows that the index, after a significant drop, paused temporarily in last 2008 before beginning the selling climax. In 2017, the red line show that after a summer pause, the Dow took off in September, adding another 1,500 points or +7%. While our intention is not to suggest that the two price patterns are perfect overlays, we do note that the tendency is for prices to make one last run (up or down) before reversing.
While a buying climax cant be predicted in advance, we know that when the market turns down, the initial drop (however sharp it may be) will come like a thief in the night. Moreover, given the numerous scary 1 to 3 day sell-offs we have experienced in the last two years (Brexit, U.S. election, June tech rout), most will believe that the next sell-off is anodyne. While this may again be the case, investors must resist being complacent in this market which has lulled everyone to sleep. There will come a time when investors will need to cut losses or take reduced profits on long equity positions during a drop in the indexes. Given the excesses in this market, we do not recommend that price-sensitive investors (especially those in index products) ride out the next down-cycle.