What Happens After This Rally

I put on my thinking cap and did some data diving. I looked at 3 periods

1. The 1990 Recession - Began July 1990 and ran into 1991

2. The 2001 Recession - Began February 2001 and lasted until late 2001

3. Recent Downturn - Began October 2007 when the Q4 '07 GDP slipped to 0.6%

Downturns are not created equal: they all have different causes. But the symptoms are always the same: low consumer spending, higher unemployment, low business investment, and a low stockmarket.

It's the latter part I want to explore. How will this downturn play out in the stockmarket. Because I want to be short when the big bear bites.

I looked but couldn't find anything, so I did my own research. I took the DOW weekly closing prices and I charted them against a starting point. I chose the day 1 year before the recessions officially started. Next, I set that DOW closing price as the starting point and compared each subsequent week's price against that price. There's no exact science so I chose a starting date equal for all periods. So I may be off somewhat in terms of measuring the high or lows, but the overall shape will be clear and that's what I'm after.

Next I looked for the rallies and crashes that accompany a recession. I defined a rally or crash as a trendline ~10%.

Comparing the last 2 recessions, we see at least one major difference: the DOW rose at the end of the 1990 recession wheras the Dow rallied and then crashed even harder. I leave it to economists to puzzle that one out, but I think the cause was false hope that the end of the recession signalled economic growth. When it didn't, the market crashed again and harder. I suspect that this time will be similar to the 2001 reaction - a prolonged drop.

There are, however, many more points of commonality.
1. In terms of depth, crashes are deep and fast, whereas rallies are shallower and slow

2. The Dow was rising as the recession starts.

3. A major rally immediately precedes the recession, like a last gasp. Prior to that point, the economic data is mixed although the downturn is in the air. During that period, the market swings in 10% cycles. Then a bigger swing up and a bigger crash down. In 1990, an 8 month run of 15% was followed by a 3 month 25% drop. In 2001, a 3 month 15% run preceded the 4 month 30% crash.
4. In terms of timing, the big Dow crash occurs within 45 days of the recession.

Why does the market swing up and down even as the GDP figures indicate a slowdown? Human behavior. Investors are driven by official reports and, prior to the recession, slowdowns are very sector specific. They are, by definition, at least 90 days late to the party - earnings releases and GDP data is 90 days after the fact. Then they panic - hence the deeper moves down.

Also, contractions are delayed across sectors. Investors tend to think of them as isolated events and respond by dumping a sector. That pushes the market down, but it rallies on strength elsewhere. Housing slow? No problem, banking is still strong.

Point #4 bears repeating: the big Dow crash occurs within 45 days of the recession.

I misread the last few months of data. I thought we entered recession and the February crash was the big crash. The one that would be 20%+.

Instead, I think we just entered the last big rally before the big collapse

If I am reading the data correctly, we could see a 15 point rally from the recent bottom. Possibly as high as 14,000. But then it will collapse to 11,200 really fast.

When? I think very soon. We get Q1 GDP and earnings releases in the next few weeks. A tthat point, investors will be forced to acknowledge:

1. It isn't a liquidity issue anymore but a true cyclical slowdown

2. It is broad based

3. It will be deeper an dmore prolonged than expected

If that 45 day rule holds, then we are almost there. We wil lhave a bit more of a rally and then a fast drop.

That is why I am sticking to my guns and staying with the short positions.