Friday's big plunge raises disturbing parallels with the top of the dot-com bubble

The parallels to the top of the dot-com bubble are close enough to be disturbing

Is that gushing sound from a bubble bursting?

It's an urgent question, given the stock market's rout on Friday, especially for the Nasdaq Composite Index COMP, which lost 748 points, or 2.9%. That certainly looks like bear-market behavior.

That's because big one-day plunges far more often than not occur during bear markets. Consider the 50 biggest one-day plunges for the Nasdaq since 1971, which is when the index was created. Forty-two of them - 84% - occurred during bear markets in the calendar maintained by Ned Davis Research. Since only 25% of all days since 1971 were in one of those bear markets, this means that big one-day plunges are associated with three-times-higher odds of occurring during a primary downtrend.

The parallels to the top of the dot-com bubble are close enough to be disturbing. Many investors labor under the illusion that the Nasdaq plunged almost immediately after hitting its all-time high on March 10, 2000 - in true bubble-bursting fashion. If that were so, then the market's recent behavior would look significantly different, since the Nasdaq today is only modestly below (5.1%) its all-time high from three weeks ago.

In fact, however, as you can see from the above chart, the Nasdaq didn't immediately plunge in March 2000. For the first three weeks following its high that month, this index was relatively flat - and only thereafter did the bottom drop out in a big way.

Will sentiment save the day?

One bright spot in the comparison of today with the top of the dot-com bubble is how quickly Nasdaq-oriented stock market-timers over the past few weeks have gone to cash. That's encouraging from a contrarian point of view, since market tops often are accompanied by stubbornly held bullishness.

Such stubbornness was very much in evidence at the top of the dot-com bubble. Consider the average recommended equity-market exposure among these Nasdaq-focused timers (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). This average actually increased over the three weeks subsequent to the Nasdaq's all-time high in 2000.

In contrast, the Nasdaq-focused market-timers today are far from stubborn. The HNNSI over the past three weeks has dropped 76 percentage points, and currently stands at 6.2% - indicating that these timers on average are now almost completely out of stocks.

The next several weeks therefore will be a test of contrarian analysis. Will its relatively upbeat analysis of current sentiment be strong enough to stop the stock market's strong downward momentum? Fasten your seatbelts.

-Mark Hulbert