The Dow Industrials index is stronger than would be expected based on average experience after prior bear markets of a similar scale to 2007-09. This “overshoot” may reflect extraordinarily loose monetary conditions.

The table compares the 54% decline in the Dow between October 2007 and March 2009 with the seven worst bear markets of the last century. Six of the seven were of similar scale, involving a fall of between 45% and 52%. The outlier, of course, was the 1929-32 bear, when the Dow plunged by 89%.

The six similar bear markets can be used to “benchmark” recent Dow performance. First, the peak of the Dow before each bear was aligned with the October 2007 high and subsequent levels calculated. An average of the six levels was then taken at each date – this “six-bear average” shows a hypothetical path for the Dow based on mean experience after prior peaks.

Secondly, the trough of the Dow after each bear was aligned with the March 2009 low and subsequent levels calculated. An average of these six levels shows a hypothetical path for the Dow based on mean experience after prior troughs – a “six-recovery average”.

The chart compares the Dow’s performance with these two averages. Though derived independently, the averages trace out similar paths after late 2009. The Dow fluctuated above and below the averages during 2010 and 2011. These over- and undershoots correlate with changes in monetary conditions caused by the Fed starting and stopping QE operations, with ECB policy apparently also an influence recently.

For example, the fall in the Dow below the averages in mid 2010 followed the end of QE1 securities purchases in March. The launch of QE2 later in the year, however, was associated with a renewed surge, pushing the index to a significant overshoot by early 2011. Another correction occurred after QE2 ended in June last year, with weakness exacerbated by wrangling over the federal debt ceiling and Eurozone sovereign debt woes. This sell-off reversed following a series of Fed and ECB actions in late 2011, including the initiation of “operation twist” in September, the ECB’s reintroduction of one-year repos in October, an injection of dollar liquidity via Fed swaps with other central banks in November and the ECB’s extension of subsidised lending to three years against looser collateral requirements in December.

The Dow is now further above the averages than in early 2011 but strength is probably warranted by extraordinarily loose global monetary conditions, as evidenced by a large gap between G7 real narrow money and industrial output expansion and record G7 bank reserves. Investors, however, should be prepared for continued volatility: another wrenching correction is likely when monetary conditions tighten, either because central banks dial back on stimulus or stronger economies divert liquidity away from markets – a possible scenario for later in 2012.