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Article / 20 March 2013 at 15:12 GMT

How do massive stock market rallies end?

John J Hardy John J Hardy
Head of FX Strategy / Saxo Bank
Denmark

Now that I am convinced we’ve moved into totally unjustifiable extremes of complacency in risky assets, I am having a look at some historic stock market breaks and how they have unfolded. In that light, the current setup is rather ominous.

Note: All charts are courtesy of Bloomberg – kudos to them for keeping such long data sets on the major US market indices.

Disclaimer: I’m an FX strategist and not an equity strategist. But I also fancy myself as a bit of a chartist and I like to look at historic patterns, particularly when the past might provide a historic parallel for the present situation. In this case, I’m interested in what many historic major equity chart tops look like in a technical sense now that if feels like we’ve entered into a blow-off territory technically. Somewhat to my surprise, I found that many major market tops had remarkably similar traits as the one we have just posted.

What is in this post?
A look at big stock market tops in the S&P500 that resemble the current situation (with the assumption that the current situation risks proving a major top), including the all-time classic 1929, but also 1969, 1973, and 1987. The resemblance is not only technical, but also due to the fact that in all instances, bond yields were rising.

The major market tops I have left out include 2007 and 2000 because they bore little resemblance to the current setup technically – though they provide very similar lessons once the top was in place – i.e., in the nature of the subsequent sell-off. In 2000, almost all focus was on bubble tech stock indices rather than the broader S&P500 (in fact – while tech crashed, does anyone realise there was a massive rally in neglected value stocks for most of 2000 and even 2001?) As well, the 2007 was unlike any of the scenarios discussed here because bond yields were falling steeply once the top was forming.

What is “the setup” or analog?
One thing that all of the episodes shown here have in common: there was a flourish of buying at the top of an already major market advance in the S&P500 index, a flourish that actually sees the index breaking above the upper bound of some kind of ascending formation, whether wedge or channel. And then that advance is quickly reversed.

Also – bond yields were generally rising – whether viciously like in 1987 or more gently as in the current episode (though today’s equivalent is any hint of a shift towards the tighter side in expectations of Fed accommodation in addition to the modest rise in actual yields – thus I’m rushing to get this out ahead of the FOMC meeting later today, which is a key event risk in that regard).

Am I calling a top?
I am not calling a top – I am suggesting that there are scary parallels in the current market setup relative to significant past market tops.

What to do?
The lesson that every single major equity top in the past offers is that one does not need to “pick a top”. The more interesting setup is what follows and confirms the top: first you get the initial sell-off that takes out the highs of the previous major wave of trend – in Elliott Parlance, an A-Wave. The size of the initial A-wave from major tops has varied tremendously over time, but even more interesting than the initial sell-off wave from the top is the “throwback” or B-wave that sees the bulls making another go for it or nervous bears covering their initial success and provides the best trading opportunities in terms of risk/reward.

After the initial sell-off, almost regardless of its magnitude, in every single case there has been a significant throwback B-wave, and that wave is almost always very close to the golden 0.618 Fibo (61.8 percent) of the A-wave’s magnitude.

To take an example – not shown below, but perhaps the most dramatic, even in 2000 after the blowout initial tech stock decline in the spring of 2000, when the Nasdaq 100 Index lost a mind-boggling 1,919 of its total 4,816 points and traded at 2,897 at its spring-time low, or nearly 40 percent off the highs from March, patient bears then saw a massive throwback B-wave rally into the summer that took it back to 4,089, six points above a perfect 4.083 retracement. That was the high until an attempt through that level in September failed and then the market went on to lose over 70 percent of its value by about 12 months later.

1929 and 1987 were relatively concentrated scenarios, on the other hand, I suspect due to the involvement of huge amounts of leverage in both cases – 10 percent margin in 1929’s case and poorly understood new S&P500 futures in the latter case. IN both instances, there was a steep run higher with very little correction and then a blow-off top. Immediately after the blow-off, an A-wave of some size removed the last spring of the blow-off, a perfect B-wave retracement formed of almost exactly 61.8 percent, and then a brutal and violent C-wave. Again, the two keys from a trading perspective are the top of the B-wave at golden Fibo’s and then the break of the A-wave low (the latter is shown with a flat yellow line in the charts below.)

So in the future, I will refer back to this post in the event an A-wave correction forms from here – see chart 1 below for what makes an A-wave in the present case.

Chart 1: The current S&P500 setup
We see two interesting things about the current setup – first that the rally has become so aggressive despite this being a multi-year bull market that it has broken the ascending wedge-like formation that has characterised the market for some time. And bond yields bottomed last summer and started coming higher again from November until recently, where we also have talk of a potentially tighter Fed.

From here, for the idea that we have a top on our hands to gain traction, the focus needs to be on whether we get an A-wave that fully retraces the blow-off top – something like a move to 1,500, though anything through 1,525 begins to break up the current bullish trend. From that A-wave low, whether it is 1,500 or 1,485 (Feb low) or lower, we’ll then look for a 61.8 percent throwback as the critical level for bearish counter-attack. And beyond that, we await the break of wherever the A-wave bottoms out – as shown with the yellow lines in all of these charts except for this one as there is no A-wave yet. The break of the A-wave low touches off a much dreaded C-wave. It’s the C-wave where the bulk of the percentage downside occurs. Stay tuned.

spx_01

Chart 2: 1987 
We can see that there was a similar sprint higher in the late summer of 1987 in an already very well established bull trend. (Yes – the market did a similar sprint higher in the spring of 1986 – but remember that the mid-1980’s equity market rally was off the inflation-adjusted 28-year low in 1982 and bond yields were collapsing in a positive growth environment in early 1986 – in 1987, by contrast, bond yields were ripping higher in March – September ahead of the crash.)

In the 1987 market – the upper bound of an ascending wedge (even using a logarithmic axis, it should be noted) was also broken in a blow-off, and things quickly destabilised from there – at the third week after the break – about where we are in 2013 in terms of blowing through an upper bound of a major formation. Then we had three weeks of selling that took out the blow-off, three weeks of throwback rallying attempts to a near-perfect 0.618 Fibo, and then an extraordinary three weeks of C-wave selling that was aggravated by portfolio insurance futures selling. Talk about a compressed bear market.

spx_2

Chart 3: 1973
A less compelling setup, perhaps, but interesting to note the sharp rally again through the semi-wedge-like formation and to note that bond yields were generally rising from late 1971 lows and continued to rise through August of 1973 ahead of this top. The throwback B-wave fell 1.4 points short of a perfect 61.8% retracement before a brutal sell-off took the index into a C-wave and eventually the 1974 lows.

spx_3

Chart 4: 1968
The 1968 top was interesting for its ending in a three-week intense buying spree (see 1987 and possibly today) that took it beyond the salient bounds of the upside of the technical formation as well... Oh, and the equity market was topping just as bond yields were spiking higher from summer lows and had moved to a multi-decade high at the time of the market peak…

spx_4

Chart 5: 1929
Not a real parallel technically, but once again note the very steep three-week sprint higher (!) followed by three weeks of doji-like compressed-range uncertainty and then a symmetric three-week full sharp retracement of that last sprint higher. Armageddon quickly followed the formation of the A-wave after a mere one week as widespread margin use (only 10 percent was required at the time) wiped out the market within a few weeks once the A-wave low was violated. I couldn’t find good data on bond yields in the 20s, but low granularity data I did find seems to suggest they were rising (any readers care to link me to some good 80-year old bond data series?), though I suspect this was a classic case of mania that simply failed as the market simply couldn’t find net new buyers and my understanding was that companies saw activity drying up very sharply in the summer before the October crash.

spx_5

 

Chart 6: Bond yields through 200 years – from Societe Generale

What a perspective – this appears to be for 10-year rates. Again, it’s important to point out that bond yields were moving higher in every single scenario outlined above – they were also rising in 2000, by the way. John Hussman of Hussman funds reminds us of the challenge posed by higher bond yields to the current rally almost weekly as he is also worried about rising bond yields. Two ways to look at this chart – bond yields must rise eventually, or real bond yields can continue to go more negative (if this were a chart of real rates – the recent lows would be even more exaggerated), so that bond holders see more and more of their savings confiscated through negative real rates. And how is either scenario good for equities?

socgen_bonds

1y
Umbeluzi Umbeluzi
Deep study, thanks!
1y
eskiln eskiln
Well written, thorough andinteresting article John! I also think that we could be near a high for now. Too much easy money and complacency at the moment
1y
nickolas nickolas
)))322
1y
goldfinger goldfinger
No trillion $ note?
1y
eskiln eskiln
Just listened to the talking heads on CNBC: "This market is bullish and gon higher!" Nothing wrong with the complacency and belief in more easy money it appears :)
1y
goldfinger goldfinger
Which market is going higher?
1y
benlouro benlouro
thanks again for this writting. very helpfull
1y
eskiln eskiln
I guess there is only one "market" when talking to Americans.. :)

PS! Writing on an iPad can sometimes mess up your vocabulary.
1y
nf1204 nf1204
If any of are interested, watch Greg Schnell's video on the 7 wedges in last century . Starts at about 2 min. in to the video.
http://media.mta.org/videos/2013/educational-web-series/greg-schnell/greg-schnell.html
1y
bakrob99 bakrob99
One thing is for sure ... we need to see a weekly close BELOW any week before the bears get fed.
1y
eskiln eskiln
This is text book material. Will refer to this so that I can be successfull when we get a correction.
1y
goldfinger goldfinger
I am not sure why indices should be heading south anytime soon. The FED is standing pat. That's $40b a month.
The UK are almost certain to do another £25b. And I have no doubt Europe will start printing. Add to that the Japanese monetary policy, and you have a world awash with liquidity.
All this debt held by central banks will never get to market and will be held to retirement, or cancelled. That will be inflationery and on balance good for equities. Unless, of course, you are considering buying inflation linked debt. Fixed rate debt will be going to hell and gone. So where is all this money going to end up?
Of course the indices are due a correction, could argue overdue a retracement, but I am sure it will be a blip. Also valuations don't look over extended...
1y
John J Hardy John J Hardy
The key is growing prospects of less accommodation from the Fed - that is one of the lessons behind the charts - liquidity drives the bulls, turning off the liquidity valve (rising bond yields) starves them. But yes, timing is very hard to choose - and I tried to stress that picking the top is less interesting than anticipating what will unfold once it becomes increasingly clear that a top is in place. Even if we do get a 2007-style situation technically, we could begin carving out a top within a handful of weeks. As shown in attached chart of 2007 episode, there was an exceeding of the upper bound of an uptrend channel. The market then found a top within several weeks followed by brutal Bear-Stearns triggered sell-off. Then there was the miraculous October top as the market misread the Fed's ability to contain the situation as aggressive easing was getting priced in leading into the September shock move to cut 50 bps. (again, that's what makes '07 different - rates were falling)
1y
nickolas nickolas
John soon!))) do not worry!
1y
Umbeluzi Umbeluzi
In this environment (with CBs playing, USA and China resiliency) any serious correction needs a very strong risk-off event (geopolitical/military, major corporations failure,any significant country default, etc) to became reality. If not, we might expect some small rains on the garden only...
1y
benlouro benlouro
agree with Umbeluzi but don´t forget: CB are loosing credit about their politics, North korea and Iran threat, Cyprus iminent default and some corporations are not selling... and of course equities are positive since September...
1y
Umbeluzi Umbeluzi
Yes Benlouro! The threats are there, it they materialize...

Have a good day!!!
1y
John J Hardy John J Hardy
That's what's nice about the technicals, gents - you just watch them unfold and don't have to "think". To double underline the point - the key is whether the Fed is headed toward a tectonic shift and toward withdrawal of accommodation after pedal to the metal for almost 6 years, whether because of a stronger US economy or because its policies have already created a credit bubble (junk bonds in particular) that ends in tears and embarrassment. We'll see - possible new appointment process this summer for new Fed chairman to replace a retiring Bernanke also a massive unknown as the Fed's role has become a hotly partisan issue.
1y
Umbeluzi Umbeluzi
Agree completely on the assumptions, so it seems we will have more time sailing in this ocean of liquidity. For me, a small trader with short term targets (days, weeks), I must trade what I see now if wants to make any money in this often erratic market.
1y
dominom dominom
yesterday I opened a long term short position on DAX based on my assessment and this article :) . thanks ...
1y
BennyBomstaerk BennyBomstaerk
Interesting and thorough analysis Kim.
Also quite interesting that you post this at the same day as this tv spot airs on boersen, explaining that the SP500 will probably increase by 30 pct over the next 3 years, citing that US stocks are generally very cheap.
http://investor.borsen.dk/artikel/1/254589/aktietip_s_p_500_stiger_over_30_pct_de_naeste_tre_aar.html.
Being an Engineer I think you are backing your point with some "real evidence" wereas the tv-spot is quite fluffy and stating predictions which would also point to an impending downturn, such as the end of QE.

So I will axiously check the chart over the next couple of weeks, but honstly probably don't have the guts to go "all cash" in antipation of whats maybe coming.
1y
Brandon Ferro Brandon Ferro
You're frame of reference is spot on, but you're a little early. Likely 1927, early 1986 or early 1989 (Nikkei). Meaning, the outcome you're predicting is likely, but there could be materially more upside (~25%-100%) and time (1-2 years) left.
1y
John J Hardy John J Hardy
Zero Hedge posted this article - if you want "colorful" commentary - have a look...
http://www.zerohedge.com/news/2013-03-22/guest-post-how-do-massive-stock-market-rallies-end
26 June
Offpiste Offpiste
Hi John, just revisiting this great post. Wondering whether we getting closer to the trigger point.... Indices retracing after initial sell-off wave? Appreciate your thoughts

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