The behavior known as “conditioned response” — made famous by Nobel Laureate Ivan Pavlov — is easy to understand.
Ring a bell every time you feed a dog, and eventually that dog will salivate at the sound of the bell even when food is absent.
If grandma baked you apple pie each time you visited, that same smell from a bakery years later would likely evoke a strong memory of grandma’s home.
Likewise, most stock market participants have by now developed a conditioned response to market downturns.
The market’s overall uptrend from the early 1980s to 2000 conditioned investors to see price pullbacks as “healthy corrections.”
This learned response became so entrenched that even the devastating declines of 2000 and 2007 did not significantly alter that perception. It’s no stretch of logic to see that conditioning at work in the three historic peaks in the Dow (see chart below):
The Dow has been in an overall downtrend since the top of that “third peak” — the May 2 intraday high of 12,875.
The “conditioned response” is in evidence:
“A ten percent correction is ‘entirely possible.'” That’s from a June 15, CNBC article which expressed the market views of a famous pundit.
A June 16 headline in Smart Money magazine emphatically reminds us of the conditioned response to market pullbacks: “Why Stocks Will Come Storming Back.” Here’s how the article starts off:
“Things have been bleak on Wall Street lately and many investors are wondering if they should call it quits. After all, it’s been a pretty good run on Wall Street across the last 18 to 24 months.
“Don’t do it. The next leg up for stocks could be even bigger.”
The article goes on to list several reasons why stocks are headed higher.
Could the article’s author be right — that the next leg up will be even bigger than the rally that began in early 2009? Or will a very different market scenario unfold?
The not-too distant future may include a time similar to what happened in the past — which breaks the overly-optimistic conditioned response.
That’s what happened after the Great Depression. Most people wouldn’t touch stocks for many years. The average household avoided equities like the plague.
Obviously that scenario is 180-degrees opposite of many recent financial articles. But before you decide whether this recent stock market downtrend is just another “healthy correction,” read the just-published Elliott Wave Theorist. You’ll discover what happened after stock market prices formed “three peaks” at another time in market history, and the similarities of then with now.
New Bear Market or “Healthy Correction”? | Elliott Wave International