June 26th, 2006

Stock Market Bottom?

Some of you have probably been wondering where I’ve been since the last post. Well, I’ve been working.

If you’re a regular reader, you know that I turned sour on the market around the beginning of May (see my May and May posts) and adopted a very negative strategy of converting to a large cash position, putting on what for me was a fairly large short position (which hasn’t turned out to be all that profitable, so far), and hedging my bearishness with a some long positions in a few
low-priced stocks and LEAPs on Sears Holding (SHLD) due to their higher volatility. I made these radical moves for a number of reasons:

  • The market, at least the DJ 30, was close to breaking into new all-time high territory yet it was essentially a non-event
  • We’ve been in a secular bear market for nearly 6 years with some predicting that it will continue for another 3-5 years because the market’s P/E ratio is not sufficiently low to launch a new bull market
  • The market had been rising fairly consistently since March, 2003 and statistically, after 3 years, was due for correction of sorts
  • We were entering the “sell in May and go away” and mid-term election year phase of the market
  • The market’s temperament was clearly shifting in the beginning of May with the sell-off in market leaders .. the energy, gold and commodity industry groups.

So what’s the temperature of the market now? While the talking heads on CNBC continue to be bullish and calling any sort of recovery as the bottom, here are some disturbing opinions I picked up over the weekend:

“We are in a bear market,” asserts Paul Desmond, president of Lowry’s Reports, which tracks supply and demand in the stock market, using proprietary indicators developed more than 70 years ago. “It’s likely we won’t see a reversal for quite some time.” He figures that the market may not bottom until the forth quarter, or early 2007, coinciding with an historical trend of market lows in or just after the second year of presidential-election cycles……The current decline is especially dangerous because many investors appear unfazed by the bearish signals….The Leuthold Group alerted its clients recently that, based on more than 40 measures of investor sentiment it monitors, the market is “nowhere near oversold territory. Saying the market is “unhealthy” and in the “early stages of a new cyclical bear market,” Leuthold warned clients in early June that a much higher level of investor “caution, fear and even some degree of capitulation” is needed before a bottom is reached. While not pinpointing a bottom, he suggests that a 5% decline in the S&P, to 1180, would bring the market to the “median valuation level” since 1957…it would take a 15% fall in the Dow, and a 23% drop in small-caps, before a similar buying opportunity would present itself.” Barron’s article “Walking the Bear” June 26, 2006

And in the Sunday NY Times Business Section there were these comments:

“While Wall Street economists debate exactly how many more rate increases are in the works, a majority of money managers now believe that the current economic expansion is in its final innings….Merrill Lynch economists see at least a 40 percent chance of recession next year, and they predict that the Fed will have to cut short-term interest rates sometime in the first quarter
of 2007….On average, the time between the end of a tightening cycle and the start of a new easing cycle has been only 5.5 months (after taking out 2 exceptions)…..The bottom line is this; It’s time for investors to pay attention to the plateau period that’s coming–and perhaps even the next economic expansion–rather than worrying about how many more rate increases are ahead ….there is no harm in building up cash positions, especially at a time when cash is offering yields that are competitive with bonds.
“What the Fed Is Up To and Why You Shouldn’t Fret” June 25, 2006

According the earlier reference Barron’s article, “the greatest danger investors face is the desire to buy too soon. Once the bear market pattern has been established, investors should get out of the way. Don’t bargain-hunt. Don’t anticipate. [Investors] should stay on the sidelines and protect themselves.” Being bullish feels safer and much more comfortable (and more fun, by
the way) for me than being bearish and having short positions. So, obviously, I’m looking for signs of when I can swing back trading.

Conventional wisdom, as codified by IBD, says that we should wait for a “follow-through”
day. An IBD article in 2005 entitled “Follow-Through Concept Evolves Over Time” outlines the concept as follows:

“A follow-through occurs at the start of a new rally. While not every follow-through launches a big move, no rally in recent U.S. market history has started without one. You’ll often see a follow-through when the market hits bottom, then starts to turn back up. The first up session is Day 1 of the rally attempt. You then want the follow-through to occur on Day 4 or later. What makes for a follow-through? In today’s market environment, it’s a day in which one or more of the major market indexes (the Nasdaq, S&P 500 or Dow) rise 1.7% or more. The gain must also occur in higher volume than the previous day.”

That Barron’s article states:

“Ordinarily, the arrival of the bear would be confirmed when the market experiences two ‘90% downside’ days, like May 17 and June 5-when 90% or more of the trading occurs in declined stocks. But sharp moves of similar magnitude both down and up in a 30-day period since the market peak in early May have led him to discount the significance of the action. Instead, a new
watch has begun for the next 90% downside day. And a real bottom.”

As a Stock Chartist, I’m looking for a metric, something more visual like a graph, that encapsulates and depicts the essence of the “follow-through concept”, “90% days” and other
quantitative measures of long-term changes in sentiment and balance between buying and selling momentum. While the S&P 500 is a thermometer measuring the actual temperature (price) of the market, there’s little judgment applied to the qualitative value of its daily up’s and down’s. So I developed, and back tested, a new metric I call “S&P500 Momentum Indicator”. For a description, come back soon and read the next posting.

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