The Stock Market: Where Do We Go From Here?

Stocks have now moved significantly lower from the recent highs bringing back some concern from market participants. The market is oversold in the short term and due for a bounce, but where are we in the long term?

To look out in the years ahead we must review our understanding of secular cycles. We are currently in a secular bear market cycle that, based on history, will probably last close to 17.6 years. For an understanding of where I get this number please see Historical Guides: Stock Market Cycles & Public Ownership.

This means we have close to 5 years remaining in the current bear market. The following chart helps visualize the bottoming process that will take place as we move forward. It shows the DOW from 1885 through today with the blue line running through the center providing the long term "trend line."

The DOW would need to fall back to 7,636 on Monday morning in order to get back to the historical trend. This obviously will not happen on Monday, but it provides an understanding of where we may be headed moving forward.

A secular bear market throughout history has moved significantly below the trend line in order to find a bottom. This process cleanses the market of all weak hands and brings the price to earnings (P/E) ratios down to levels that create undervaluation. The market only touched the long term trend line at its lows in March of 2009. It did not move below.

That is the long term. Most people are concerned about where we are heading next week, which I of course, have no idea. However, to get a better gauge of the short term movements within a longer term secular cycle you must follow sentiment indicators.

The following excellent chart from The Technical Take shows the market movement (top blue line) in recent months. The line below it shows the composite index of four key measures of investor sentiment:

1. Investor Intelligence Survey
2. Market Vane
3. American Association Of Individual Investors
4. Put/Call Ratio

When market participants are more optimistic about the future direction of prices the index moves up. When they are more pessimistic the index moves down. Historically these four groups have been on the wrong side of the trade. This means when they are optimistic you should be very fearful.

During most of 2012 the line moved upward into the bullish category (the bottom line turned red flashing danger). During this current decline it has fallen significantly and is now in the neutral camp (line has turned blue). When it turns green it means that they are pessimistic creating the opportunity for a short term bounce in the market.

For a more detailed discussion on the important of sentiment see 2012 Real Estate Outlook: The Fall (2006 - 2011).

h/t The Big Picture