Note: The six-bear average, referenced in several posts over the last year or so, is a history-based “forecast” derived from the recovery path of US equities after the six twentieth-century bear markets that involved a fall in the Dow Industrials index of about 50%. (The Dow fell by 54% between October 2007 and March 2009.) At yesterday’s close of 11247, the Dow was 1% above the average, which falls to a low in late October before embarking on a year-long recovery – see first chart below. A post from May 2010 details the component bear markets and subsequent equity market performance. The last update was in early August.
Reader’s comment: It looks to me like the average in the next couple of months comprises one very positive outcome and five outcomes that are about 10% lower than where we are now. Which bear market is the really positive one? Is there any reason why we should not be looking at the average excluding that one? On this basis there would be significant short-term downside from here as the reality of slower economic recovery and growth gets fully discounted?

Answer: Many thanks for your interesting question. The positive outlier is the rise from the bear market low of June 1901 – the earliest of the six cycles included in the calculation of the average. A “five-bear average”, excluding this rise, is currently 7% lower than the six-bear version. Moreover, it falls to a bottom 14% below the current level of the Dow by late December, as the following chart shows.

To exclude the post-1901 rise from the calculation, however, would seem to me to be unscientific, displaying bearish bias. The six bears were chosen simply on the basis that, like the 2007-09 episode, they involved a fall in the Dow of about 50%. If I were to omit the post-1901 rise because it looks too bullish, should I not also exclude the most pessimistic of the six scenarios, for balance?

A further point, which was not evident in the original chart (above) but is in the one below, is that the post-1901 line switches from being well above the average to below it during the course of 2012. So the five-bear average ends next year above the six-bear version, and above the current level of the Dow.

Whether or not the post-1901 rise is included, therefore, the analysis suggests that buying now will yield a profit on a 12+ month view. The issue is the extent and duration of any further near-term weakness.