To print article, click Print on your browser's File menu. Go back Posted 11/18/2003

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The Speculator
Dow 10,000: Careful what you wish for
 

The Speculators look at the history of the index at milestone numbers and conclude that moving above the 10,000 level is fraught with risk.

By Victor Niederhoffer and Laurel Kenner

There are 1,001 reasons why the Dow Jones Industrial Average’s potential break above the magical round number 10,000 is laden with predictive value. But looking at the possible crossing through the lenses of psychology, economics and history, we fear that the market's currently lofty level will not be seen again for a long time.

Consider some broader anecdotal evidence on the bearish properties of round numbers:

 

• Whenever the Dow ($INDU) has crossed a number ending in three zeros from below during the day, it closed lower on 13 of those 17 occasions.
   
• Years ending in “0” are particularly bearish. In no “0” year has the market gained more than 15%. All years ending in other digits have had higher highs.
   
• Exceptionally severe declines occurred at the turn of the 19th and 20th centuries.

Round numbers somehow push whole rows of buttons in human psychology. They are the financial counterparts of the vivid events that psychologists say set off a “flashlight effect” in our brains. This flashlight effect accounts for why most people recall exactly where they were and what they were doing when something really big took place: the terrorist attacks on the World Trade Center, the explosion of the space shuttle Challenger in 1986, and John Kennedy’s assassination in 1963.

Countdown 2003 Sort through the year's rogues and rallies.

A vivid memory will shape a judgment
People always have to make quick decisions, and, in doing so, they are apt to base their judgments on memories of vivid events of one sort or another. Logic is not always served by these shortcuts. Nobel Prize winner Daniel Kahneman and the late Amos Tversky documented two biases that may be particularly applicable to Dow 10,000:

 

• Anchoring -- the tendency to jump to conclusions based on an initial event.
   
• The availability heuristic -- the tendency to estimate the frequency of events from the ease with which such an event or events are remembered.

Other psychological biases come into play, as well. When prices move to a round number from below, the incremental move seems much greater than the actual numeric move. That’s why $9.99 is more common in the retail business than $10.00.

Roger Heeler and Adam Nguyen, researchers at York University in Canada, found that prices around the world are almost universally quoted slightly below round numbers -- $9.99 instead of $10.00. In Asia, where “8” is considered lucky, the price is likely to be $9.88. (To see their article, “Price Endings in Asia,” click here or on the link at left under Related Articles.)

The implication for investors: There should be less demand and more supply at the round number -- a decidedly bearish situation. But there's a flip side: When prices fall below a round number, it should be a relatively bullish signal.

That round number can be a trap
Because bulls and bears alike set their goals based on hope and fear at round numbers, much potential trade is waiting to transpire there. The market loves extra trade at any number, because it helps pay for its upkeep. Plus, extra trade gets both bulls and bears leaning on the wrong foot so that they can be taken advantage of in the future. Why is this? There are a few seemingly contradictory reasons, including:

Round numbers seem to act as magnets. They pull prices to themselves from both sides. And the gravitational attraction of the round number causes some investors to panic. Benjamin Graham, the so-called “Father of Securities Analysis,” got out of the market completely at Dow 500 in 1956 and stayed out until his death in 1976 -- by which time the Dow had basically doubled.

Round numbers also sometimes seem to exert magnetic repulsion. The Dow took 76 years to cross 1,000 for the first time in intraday trading, on Nov. 10, 1972. The average fell that day to close at 995. It closed above 1,000 four days later and bobbed up to 1,051 on Jan. 11, 1973 -- a high it did not surpass again until the fall of 1982.

Big numbers generate complacency. The Dow has been back and forth across 10,000 numerous times since it first topped the mark in intraday trading on March 16, 1999. What’s unusual about the latest attempted crossing is that none has occurred from below for more than six months. Unfortunately, big milestones in the market are like other big achievements in life -- they tend to be acmes. Post-high complacency is all too common.

Taking pencil to paper, we considered all the times that the Dow has crossed a number ending in three zeroes from below, after being below it for six months or more. These 17 occasions have, on average, been rather bearish, as one might expect in cases of post-high complacency.

 

*1,000-point marks crossed from below after a 6-month hiatus

As the table shows, the market tends to fall slightly in the next week, with the decline averaging -0.5% for the 17 instances recorded.

Not all is bleak
The mean change 90 days after the crossing was up 3%. And 200 days later, the gain was 6.4%. But that’s about the equal to the normal change in any 200-day period.

Here’s one plausible scenario, based on our research, of how things might play out when the Dow crosses 10,000 again.

 

• Fearful investors who have all their money in money market accounts paying less than 1% a month will conclude that the market is back at last. They will call their brokers to place buy orders. (They will soon lose money.)
  
   
• At exactly the same moment, pessimists will decide that the market has become irrationally high, and they will call their brokers to sell. Market-hating gurus who survive by selling newsletters will use Dow 10K as one more reason that Dow 1K is on the way. (They will be wrong also.)

Thus, both the bulls and the bears will be on the wrong foot, and that is what the market loves.

Final notes
 

A workout of our study of 1,000-point milestones is available on our Web site, www.dailyspeculations.com. If you have questions or comments on this article, please feel free to write to us at gbuch@bloomberg.net.

We are never content to merely count out the likely impact of an event, to study the best academic literature on the subject from the worlds of economics and psychology, and develop our own predictions based thereupon. That’s the old-fashioned way. The modern way is to search the World Wide Web for the best ideas that have appeared in any context in any country.

In the course of studying the tens of thousands of articles on round numbers and vivid events, we came across an insightful review of factors that come into play when new levels and goals have been achieved. The authors of this review noted that early 20th century psychologists studying perception had observed that people organize complex visual fields into coherent wholes, or gestalts, rather than seeing unrelated elements in isolation. Recall the famous picture of the vase set off by profiles, illustrating how the mind can use two frames of reference for the same picture. The article said some of the insights on perception developed by these Gestalt psychologists are directly applicable to the market, including one called the Law of Closure: “Parts of a figure that are not presented will be filled in by the perceptual system.”

Imagine our surprise when we found that the authors of this philosophical construct had applied their theoretical insights into a system on what happens when IBM ends in two zeros, like 100. They concluded that breaks above were bearish and breaks below were bullish, just the way we did. Extensive detective work revealed that this article "A swingin' Gestalt theory to rock your stocks" appeared on MSN Money on Nov. 30, 2000. The authors: us.