The History of Human Behavior Suggests a Stock Market Rally

I love trading stocks. It’s all numbers and charts. And they speak to you. They really do. What they tell you is the story of human behavior. I’m convinced that Sigmund Freud, had he been alive today, would have been a trader. Of course he likely would have considered the “candlesticks” we traders use on our charts phallic symbols, but that’s another matter altogether.

If you believe that human behavior doesn’t change no matter the era or circumstance then it might well be time to go long. Psychological indicators have been pointing to a market turn for months and if you bought into them up until now you might have suffered even further losses. But there’s one that hasn’t been much discussed and is far more convincing.

The United States of America has suffered twice in the last century from manic financial bubbles. The first was that of the post World War I era. America was home from war and had emerged as an industrial behemoth. Prosperity washed over a suddenly burgeoning middle class. And it was all made possible by unprecedented innovations and Ford’s mass production. The stock market began factoring in a great new lifestyle, unparalleled in human history. And it soared. From late August 1921 until what was, as Frederick Lewis Allen tells us in his wonderful narrative of the 1930’s “Only Yesterday,” a hot and steamy day after Labor Day in New York in 1929 the Dow Jones Industrial Average gained 504%. This was a period of just over 8 years.

The second bubble was even more spectacular. It’s hard to define when it began as it was part of a larger uptrend that began during the 1980’s when the country exploded with entrepreneurial activity surrounding the development of the personal computer. But if we date it from the period after Iraq invaded Kuwait in late 1990, when America began to feel the effects of its “peace dividend” from the victory in the Cold War, the gain to the bull market peak on March 10, 2000 was an astounding 1489% in nine and one-quarter years. If we date it from the emergence from the 1994 correction in December of that year, after the Republicans took control of the House restoring divided government and the market began focusing on the incredible promise of the Internet, the gain was still an impressive 622% in just five and one-quarter years.

During both periods behavior was the same. Stocks only went up. Everyone knew that as an immutable law of nature. And many borrowed money to buy them. The manic behavior begat greater gains. And then, inevitably, it all came apart.

But this is only the prelude to our story. The most important part is yet to come. We are all familiar with how recognizable human behavior contributes to bubbles. This has been well documented. But what many don’t appreciate is how it continues apace in the aftermath, after the bubbles burst. Mark Twain once wrote, “History doesn’t repeat but it often rhymes.” The tales of the Dow and the NASDAQ after their Waterloo’s offer stunning correlation. By studying them savvy traders might position themselves to write profitable poetry from such rhymes.

After the Dow topped in 1929 the index lost 89% in 1039 days to July 1932. After the NASDAQ peaked the loss was 78% in 944 days, to October 2002. Not correlative enough for you? Read on.

After bottoming out both indices began a multiyear advance. The Dow took 1706 days to get back to within 49% of its bull market high in March 1937. The NASDAQ rallied for 1847 days and got back to within 44% of its high in October 2007.

Then the indices began correcting again. The Dow dropped 50% in 386 days, taking it 74.75% from its bull market peak by March 1938.

And the NASDAQ? The jury is still out. We won’t know with certainty where its next bottom lies until well after it makes it. But to its recent low on November 21^st the index fell nearly 55% – and here’s some poetry for you – to 74.76% off its bull market peak in 387 days.

Have we hit the bottom of this cycle? No one can say for certain. But if past is prologue the odds favor a handsome rally. To give us an idea of what’s possible if this correlation continues let’s review what the Dow did when it began its second broad rally off the burst bubble.

The Dow went on a 63% spree to take it to within 59% of its bull market high in November 1938. It all happened in just 224 days.

A similar gain in the NASDAQ would take us to next year’s July 4^th holiday and lead us above 2100 on the index from its recent bottom under 1400.

If past continues as prologue there are some unpleasant times ahead after this projected sprint. As you might have noticed the Dow’s second bear market rally made a lower high, falling short of the first rebound effort. The quick gain was slowly faded over a painful period of more than three and one-half years. While the index never again matched the bear market lows of 1932 all of the gains of the two bear market uplegs launched since that point were erased.

The Dow made its final significant low in the Summer of ’42 (a catchy phrase that someday I might use as a book title) after the United States won the Battle of Midway in World War II. The market never looked back from that point. Long before it was apparent to most observers the market had declared the war over and the United States the victor. Funny how markets have that predictive capacity. Bombs were dropping, soldiers were dying, and the stock market was pricing in the scent of a victory that only it could smell.

We could well have some ugly and difficult times ahead. All the more imperative, then, not to miss the coming rally on the NASDAQ. A rally that, if it correlates to the Dow’s behavior in the late 1930’s, could be the last significant chance to make meaningful money in the stock market for a number of years.

Of course, we true optimists believe that in the years ahead there is another “Battle of Midway” moment in our future. Hopefully it won’t be military but in a gentler if equally competitive arena. The market will start pricing in the scent of yet another victory. And savvy traders who know human behavior will recognize the aroma.