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Why the Dow Could Rise 54% in the Next 12 Months
By Tom Dyson
March 26, 2007
"Downside risk is substantial," wrote a legendary trader to his shareholders after the crash...
On September 11, 1986, the Dow Jones fell 87 points... or 5%. This was – at the time – the largest one-day fall in points of the Dow Jones' 100-year history.
(The previous largest fall was 40 points in October 1929. On Black Monday, October 1987, the Dow fell by 508 points. The largest drop in history is 685 points... when the markets reopened after 9/11.)
In the four years preceding the crash, the Dow Jones had gained 142%. Not only was this a strong bull market, but it was steady, too... there hadn't been a 10% decline in the market for almost three years.
The first reaction to the 87-point drop was panic. The press blamed computer glitches... then they blamed the expiration of options and futures. Interesting fact: The term 'Triple Witching Day' was coined that day to describe the third Friday of every March, June, September, and December when all the option and futures contracts roll over.
The second reaction was negative sentiment. After the dust settled, the press cranked out hundreds of articles explaining why it marked the beginning of a global recession and an end of the long bull market. I found a letter from legendary trader Michael Steinhardt summing up the sentiment to his shareholders in early 1987...
"Either the economy will weaken or, if it picks up, interest rates will rise," he wrote.
Then he pointed out how dividend yields were low, there were few values left, P/E ratios were extended, and the proliferation of new derivative instruments had greatly increased potential volatility. "Downside risk seems substantial," he concluded.
The funny thing is, the circumstances of the 1986 mini-crash seem so similar to the circumstances of the 400-point crash we saw three weeks ago...
- Both crashes followed a long stretch of low-volatility bull market...
Longest Stretches of Low Volatility in History |
1962-1965 |
39 months |
1984-1987 |
37 months |
1991-1994 |
36 months |
2003-current |
48 months and counting... |
- A huge outpouring of negative sentiment followed both one-day falls. The day after our most recent mini-crash, the put-call ratio spiked to an ALL-TIME high. And again, the press is full of talk of recession, twin deficits, the weak dollar, the yen carry trade, and the beginning of volatility.
- The 1986 mini-crash occurred during a huge private-equity, merger, and buy-out mania, sponsored by Michael Milken's junk bonds. We're surfing on a similar wave of deals too.
- Investors then were still nursing wounds from the vicious bear market that ended four years earlier. It's the same way now.
Here's the thing, by August 1987 – less than 12 months after the mini-crash – the Dow had gained 54%.
Now, I'm not predicting the Dow will gain 54% and hit 18,000 in the next 12 months – although it certainly could – but I do have a theory:
Bull markets live and die in three stages. The first I call the "tip-toe" stage, when professionals and insiders start to accumulate. The second stage is the "wall-of worry" stage. The public is starting to enter the market, but with trepidation. And the third phase is the blowoff phase or mania. In this phase, there is 100% conviction in the bull market's rationale.
We haven't seen a blow-off top to this bull market... and given the huge spike in fear of the last two weeks, I conclude we're still in the "wall of worry" stage.
As an investor, I'm buying U.S. stocks with strong cash flows and big dividends. As a trader, I'm buying call options on the Dow.
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