The Reflex

Is there a better way to start the week than with Duran Duran? Couldn’t resist . . . this one’s for you Vance!

The Reflex . . . Compliments of Dr. Hussman’s Weekly Market Comment:

To offer some perspective of how major peaks have typically evolved, the following charts present the Dow Jones Industrial Average in the final advances toward, and the few weeks after, what turned out in hindsight to be major stock market peaks. For reference, let’s examine the recent market peak. Notice several features:

1. A series of moderately spaced peaks forming a broad sideways “consolidation” over several months;
2. A breakout from that consolidation, leading to a steep and only briefly corrected speculative blowoff into the market’s peak;
3. A steep initial selloff from the market peak, and finally;
4. A “reflex” rally (classically on low volume – indicative of a short-squeeze with sellers backing off) that retraces much of the initial selloff.


One can observe that same general dynamic in the chart below – a series of moderately-spaced peaks forming a largely sideways consolidation, a breakout to a steep and only briefly corrected speculative “blowoff”, an initial retreat, and finally a reflex rally. This chart depicts the final advance to the 1929 market peak.


Largely the same dynamic was evident in the advance to the 1973 peak (after which the market lost half its value into late-1974): a series of moderately-spaced peaks comprising a broad consolidation, a breakout to a steep and only briefly corrected speculative blowoff and market peak, a steep initial decline, and a short-lived reflex rally after the peak.


Though the “separating decline” after the mid-1999 consolidation was quite deep, as was the initial decline from the January 2000 peak in the Dow Industrials, the same essential features were evident then as well. The correspondence isn’t nearly as pretty as in the present instance, or those of 1973 or 1929. It’s worth keeping in mind that despite a hard initial decline, many (though not all) historical bull market peaks include an “exhaustion rally” anywhere between 2-9 months after the market peak, which can carry prices within a few percent of the high. The problem is that there is too much variability to count on either their timing or extent.


From the standpoint of investor psychology, it seems understandable that the speculative enthusiasm and short-covering that contributes to bull market tops is fueled when the market “breaks out” after a period of consolidation (and what Lindsay called a “separating decline”). The blowoffs that followed – both recently and in the examples above – were accompanied by clear overvaluation on reliable measures, and also featured clearly defined overbought conditions and lopsided bullish sentiment.

Regardless of the patterns that have emerged in recent months, it’s important to recognize that the implications of extremely overvalued, overbought, overbullish conditions are not necessarily immediate. In 2000, the March high was followed by a series of retreats and recoveries, with a marginal new high in total-return terms as late as September 2000 before the market lost half of its value. In 2007, the August high was followed by an initial retreat and recovery into a very marginal final peak in October 2007 before the market lost half of its value. In 1972-73, an initial decline of nearly 20% from the market peak was followed by an advance in October 1973 that brought the S&P 500 and Dow Industrials within 7% of their highs before completing a near-50% market loss. In contrast, the reflex advances from the 1987 and 1929 peaks were rather short-lived, and were followed by steep losses within a span of weeks. Market cycles often display regularities, but investors should never conclude that they follow precise rules.