Watch Out for Bears Bearing Charts

There has always been a battle between bulls and bears in the stock market, with each side having their own reasons why the markets will definitely go in their favor. Commonly cited evidence includes such factors as unemployment, market valuations, interest rates, and the appearance of bubbles.

But market bears have found a new piece of evidence to support their position and this one looks far weaker than the other ones.

Scary chart 1
In late 2013, a new chart comparison emerged that foretold of an impending crash in the Dow Jones Industrial Average and S&P 500 . It was going to be 1929 all over again, and market bulls were doomed!

More specifically, a chart went viral showing a comparison between the run-up to the 1929 crash and the performance of the Dow Jones Industrial Average since mid 2012. The chart showed a close comparison between the markets for the past 1.5 years capturing a high number of minor dips and pops during the timeframe. Even more scary, two months after the comparison was first released, the market continued to follow the in the comparison's footsteps.

So should investors run for the hills? Well, it's too late to do so anyway. If the chart comparison prediction was correct, the big crash would have already happened beginning in March, seeing the market off nearly 50% by the beginning of last week.

Why didn't this previously correlated chart not correctly predict the next big crash? There are multiple reasons, but I'll start with the chart-specific one. At first glance, the comparison looks almost exact, with both markets rising at a similar rate. But digging deeper, it's revealed that the scale is changed to bring the movement more in line. Removing the scaling from the chart results in a chart showing the 1929 market rose significantly higher on a percentage basis than the 2012 to 2014 market.

The market and economy also had many fundamental differences from 1929 and 2014. In 1929, the market had been moving higher for seven years (two years longer than the current bull market) and the Dow Jones Industrial Average was over three times the level of the previous peak (which occurred around 1920) compared with the current market, which is less than 20% above the 2007 peak. The market factors themselves were also a lot different. Internet companies were nonexistent, the regulations of the New Deal had yet to come about, stocks were assets for the wealthy, and there was no high-speed electronic trading.

Scary chart 2
With the 1929 comparison chart heavily criticized when it was released and the chart subsequently proved wrong, you may think that marks the end of the scary chart comparisons. But another chart has been released comparing the last 1,275 days of the current bull market with the run-up to the 1987 crash, lasting 1,274 days. With the timeframes being similar and the percentage increases being in the same general pattern, this chart could frighten some investors. However, the chart also shows the 1987 market had a greater percentage gain and had an even steeper rise in the months leading up to the crash.

The close correlation over time is also not as convincing as the improperly scaled 1929 comparison chart with the 1987 comparison chart showing significant deviations from the comparison pattern in the 400- to 600-day period, the 700- to 800-day period, and the 900- to-1,000 day period. With the chart showing so many differences in the comparison during the past, it's tough to see how it has the reliability to predict the end date for the current bull market by simply identifying the length of the 1982-87 bull market.

Dangerous patterns
It's ingrained in humans to identify patterns, so looking at chart comparisons that predict a market meltdown can be very scary. However, when one looks closer, many flaws appear in the comparisons.

This is not to say that investors should ignore all arguments indicating a downside to the market, but better indicators of a market downturn would come from actual macroeconomic factors and corporate performance rather than chart comparisons to previous crashes.

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Alexander MacLennanhas a broad-based portfolio mostly long on stocks. He owns no shares of any companies mentioned in this article. The Motley Fool recommends and owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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