What to Expect After a 2,000-Point Dow Drop

While Dow declines like those we saw Monday are usually followed by a rebound, the market often retests the low, writes Mark Hulbert.
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I have both good and bad news about the Dow Jones Industrial Average’s 2,000-plus point drop on Monday.

And then I have even more discouraging news.

The good news is that drops as big as Monday’s -- 7.79% for the DJIA -- are typically followed by at least a short-term rebound. In all but one of the 11 times since 1896 in which it dropped this much, for example, over the subsequent month it was higher in 10 cases.

The bad news is that, following a short-term rebound, the market often retests the low hit on its initial big down day. This is why traders often recommend that we wait to see if that retest is successful before jumping back into the market.

Now for the discouraging news: Stop asking if we’ve finally registered the correction’s (bear market’s) low. From the perspective of contrarian analysis, the final low won’t come until we stop asking.

U.S. stocks tanked Monday, global stocks sank and bond yields were sharply lower as investors' fears about the spread of the coronavirus deepened and oil prices plunged as producers argued over how to cut production and lift prices in the face of weaker demand. The Dow Jones Industrial Average finished down 2,013 points, or 7.78%, to 23,851, the S&P 500 declined 7.6% and the Nasdaq sank 7.29%. The Dow had its worst day since December 2008.

All three of these points were experienced the last time the DJIA dropped by as much as it did on Monday. That prior occasion was Oct. 15, 2008, in the depths of the Financial Crisis. Sure enough, the market recovered some of its loss over the subsequent month, with the DJIA gaining 3.0%.

But, as we know now, that turned out to be nothing more than a dead-cat bounce, and in subsequent weeks the market fell back and then failed its retest. When it finally bottomed on Mar. 9, 2009, the DJIA was more than 20% lower than its Oct. 15 close.

As evidence of how almost everyone had stopped looking for a bottom when that bear market low finally came, consider the average recommended equity exposure among several dozen market timers who focus on the Nasdaq market (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). Because this sector of the stock market responds quickly to changes in investor sentiment, the HNNSI is the most sensitive of any of the sentiment indices I calculate.

On Mar. 9, 2009, the day of the bear market low, the HNNSI stood at minus 67.9%, which means that Nasdaq-focused market timers were allocating an average of two thirds of their equity portfolios to going short. That was one of the lowest readings for the HNNSI since 2000, when I began calculating it. On Oct. 15, 2008, in contrast, the day the DJIA dropped by as much as it did on Monday of this week, the HNNSI stood at minus 37.5%, or more than 30 percentage points higher.

The bottom line? Don’t invest any cash in equities just yet. You’ll likely get another opportunity in coming weeks.

How often should we expect drops as big as Monday’s?

I also want to put Monday’s 7.79% drop in the context of the research I reported on two weeks ago. In that column, you may recall, I reported that a group of mathematicians, physicists, and finance professors had derived a complex formula that predicts the expected frequency of big daily market drops over long periods.

According to that formula, a drop as big as Monday’s should occur every 6¼ years, on average. Since the last time the DJIA dropped as much was in October 2008, more than 11 years ago, we’ve been beating the odds -- until now.

Though that doesn’t erase the losses our portfolios just incurred, there perhaps is some solace in knowing that, from a long-term perspective, there is nothing particularly unusual in suffering a drop as big as what we suffered on Monday’s.