Irritated by the seven month itch

The 22nd anniversary of the Crash of ’87 just passed. Right on cue, some investors began to speculate on the likelihood of another.

Rest easy. The past provides clues to the market’s behaviour in the run-up to a crash and the current market profile does not match any of the necessary pre-conditions.

The Crash of ’87 was preceded by a six-year advance. Shares peaked in mid-July 1987 after almost quadrupling. The initial sell-off was minor. Prices fell 11 per cent in the next five weeks. A fresh rally then kicked in but soon faltered. Shares began to drift down a second time. Prices eventually slipped below the previous month’s low. Black Monday occurred soon after, when nervous investors suddenly pulled the plug.

A similar pattern occurred in the run-up to the 1929 Crash. Wall Street rose almost sixfold during an eight-year run. A sudden sell-off dragged prices down 15 per cent. Again, a bounce-back ran out of steam. Prices dipped for several weeks before a selling panic suddenly occurred.

We all know that definitive statistical studies need more than two data points. Even so, these trends are quite similar. Each crash was preceded by a powerful multi-year rally. Peaks were followed by sell-offs and weak rebounds. A second down-wave then ran for several weeks before a headline-grabbing crash finally occurred.

As far as this year is concerned, none of these pre-conditions has occurred. If anyone wishes to wager with you that a new crash is about to occur, history advises you to take the bet.

Although I do not expect a full-fledged crash, I do worry about a correction. I have already prepared for one by cutting the amount of money that I put on each new trade and now keep a large chunk of my investment fund in cash.

But prices have risen since I became more defensive. This is quite frustrating. One option is to “tough it out” but, in investing, stubbornness is virtually always a recipe for disaster.

On the other hand, I keep spotting warnings that trouble may lie just ahead. The “Seven- Month Trend” is a good example.

Recall that UK shares rose 42 per cent in the first seven months of the current bull run. I found four other instances when a new bull market kicked off with a powerful rally that raised prices by at least one-third in the first seven months.

Another powerful rally began two years later. Share prices rose by more than one-half in the first seven months and then temporarily faltered. Shares fell by 7 per cent in the next two months.

The granddaddy of all opening rallies was in 1975. Shares rose 107 per cent in the first seven months. Prices then reversed and fell 21 per cent in the next two months.

This seven-month figure pops up with remarkable consistency. The fourth biggest rally in the 20th century occurred in the second half of 1932. Daily closing price data did not exist then so I had to make some educated guesses. But here, too, share prices appear to have peaked around the seven-month mark after gaining 37 per cent. Prices then slipped around 13 per cent in the next three months.

Every investor knows that history does not precisely repeat itself. Nevertheless, the data make a provocative point. Powerful opening rallies usually run out of steam around the seven-month mark. The dip that follows is usually at least 10 per cent.

Our current advance has been underway for more than seven months. If history is any guide, it is ripe for a temporary pull-back.

Stock market historian David Schwartz is an active short-term trader writing about his own trades and strategies. Send any comments or suggestions to tradersdiary@ft.com