“Buy the dip.” We hear this advice all the time. Every market sell off, even a dip of just a couple percent, leads to a chorus of analysts telling us to buy the dip. Left unsaid is that every major decline and every bear market begins with a dip.
As investors, our challenge is to distinguish the dip from something more significant. Doing this seems to require knowledge about the future. To be 100% accurate, it would require that knowledge. But, there are some useful guidelines investors can use to determine when a bear market is beginning.
There is no doubt October 1987 was a bear market. The Dow Jones Industrial Average fell more than 20% in one day that month. For many investors, the crash was unexpected. But, chart watchers would have had ample warning that a decline in prices was underway.
The chart from 1987 is shown below. The up trend is highlighted with a blue arrow. This trend peaked in August. The day of the crash, October 19, is the last red candle stick shown on the chart.
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To understand the up trend we should remember what an up trend is. The simplest definition of an up trend is that prices are trending higher when we have a series of higher highs and higher lows. From May to August, the trend was clearly up.
However, the selling in August pushed prices to a low that was below the previous two lows. This was a sign the trend was reversing. That is shown with the longer black line in the chart.
The rally from that low failed to set a new high. This confirms the trend is no longer up. Prices then reached another new low. Chart readers would have seen the market was no longer moving up by the end of September. Four days before the crash, the Dow broke through the second black line on the chart and gave a sell signal.
For traders still not willing to believe the trend had reversed, the break of the 200 day moving average on October 15 should have provided a sell signal. The crash came immediately after that.
Spotting the reversal is relatively easy in hindsight. It was the combination of signals – lower lows, lower highs and a break of the moving average – that gave the warning the trend had reversed.
Many traders believe 1987 was exceptional, and the size of the crash was exceptional. However, the market action was not. We see similar patterns emerge in nearly every bear market. The pattern of higher highs and higher lows is visible in the next chart which shows the market in 1990.
This bear market was triggered by Saddam Hussein’s invasion of Kuwait. Once again, many investors were caught off guard. However, the chart pattern was warning of a trend reversal. In July, as news stories about Iraq troop movements were in the press, prices began to weaken. The break of the moving average again provided a definitive sell signal before the bear market began in earnest.
Again, the weakness is clear in hindsight. It is the cluster of signals that carries significance. It is rare that any one signal will ever be all that is needed to spot important trend reversals. But, the appearance of several signals, is dangerous to ignore.
You may have noticed on the charts we are simply showing the price action and one moving average. Momentum indicators or multiple moving averages could be shown. But, a focus on price action is all that is really needed for long term investors to avoid most of the harm of a bear market.
Relying on this simple technique can also help avoid false signals as shown in the next chart which shows the action of the Dow in the summer of 1991.
Here, we see a sell off that was a dip. Notice how the prices remained above the 200 day moving average. That was a signal that the selling was a dip rather than the start of something more significant. This sell off was driven solely by a news event.
In August 1991, there was an attempted coup in Russia. The country was just emerging from decades of Communist party control and no one knew how the transition would go. When news of the coup broke, traders sold. When the coup ended, the buying resumed.
The long term chart below shows that stock prices rallied for most of the 1990s. There were few breaks in the trend in that decade. The chart below is a monthly chart and shows the 10 month moving average, which is roughly equivalent to the 200 day moving average.
The top of the bull market is highlighted with trend lines. By now, you realize the pattern of lower highs and lower lows is the tell tale sign of a market top. The break below the moving average should be the confirmation for traders who held out hope for too long that the bull market would resume.
Previous bear markets, even the ones that surprised investors at the time all showed a similar pattern. Prices dipped from a high and undercut previous lows. Then, the rally failed to reach a new high and the bear market began. A break of a long term moving average confirmed the significance of the sell off.
None of those characteristics are found in the current market environment. A chart of the Dow is shown below and the series of higher highs and higher lows is intact on the monthly chart. The trend is definitely up at this point.
Until a previous low is taken out on the chart, declines should be considered dips. The concern many investors have is that the market is extended. The bull market has now been in place since 2011 when the sell off did break the up trend that began in 2009.
That means the bull market is at least six years old. There hasn’t been a recession since 2009. These facts worry some investors but bull markets and economic expansions do not die of old age.
This is now the third longest economic expansion in US history. The longest lasted ten years and included the bull market from 1991 through 2000. Economists at Goldman Sachs believe the current expansion could break that record.
The longest economic expansion in the world is 103 quarters, more than 25 years. That streak is underway in Australia. Economists attribute the world record for expansions to the Netherlands which did not experience a recession from 1981 to 2008.
This means investors may be nervous but the bull market could continue. But, there are important levels on the charts to watch.
The Dow is an excellent index to use as a benchmark for the overall market. It is narrow, consisting of just 30 stocks but is highly correlated with the S&P 500 or other indexes which include more stocks. For now, the Dow is at record highs.
An important level to watch is 21,200. If the Dow falls below this price, for now, that would breach an important low. If the Dow falls below this level and rallies, the failure to reach a new all time high would signal a potential end of the bull market.
If the Dow breaks these support levels and falls below its long term moving average, the trend will have reversed. Until that happens, declines should be considered pull backs and they are buying opportunities for investors who rely on data, rather than fear, to make important decisions.