October 30th, 2008

Extrapolating to the "All-Clear"

“As long as stock exchanges have existed, analysts and investors have always placed heavy emphasis on the difficult task of identifying the primary trend of the stock market. Everyone’s ideal market strategy is, at least in theory, to avoid the ravages of each bear market, and then to move aggressively into stocks after each important market bottom. To further maximize the benefits of a new bull market, time is of the essence. An investor should buy as close to the final low as possible. This is the ‘sweet spot’ for investors — the first few months of a new bull market in which so many stocks rise so dramatically.”

The above is from an excellent report written in February, 2002, about a year before the Tech Bubble Crash bottom by Paul Desmond for Lowry’s Reports Inc. entitled “Identifying Bear Market Bottoms and New Bull Markets“. Lowry’s approach compares the activity of buyers and sellers to see which is strongest. To do that, they break NYSE trading volume into two parts:

  • Upside (buyers) Volume and Downside (sellers) Volume as well as
  • the full and fractional dollars of price change for all NYSE-listed stocks that advanced each day (Points Gained) and the full and fractional dollars of price change for all NYSE-listed stocks that declined each day (Points Lost).

Their research concludes that a bottom is indicated shortly after several “panic selling days”, defined as days where “Downside Volume equaled 90.0% or more of the total of Upside Volume plus Downside Volume, and Points Lost equaled 90.0% or more of the total of Points Gained plus Points Lost” is followed by several “panic buying days”. The information needed for this analysis is available in the daily Wall Street Journal.

Another approach indicator to determining whether a bottom has been reached is by monitoring the change in stock and index prices directly. I wrote earlier about the “Golden Cross“, when the 50-day moving average crosses above the 200-day moving average as both are rising. The “golden cross” is viewed as a positive by market technicians, as it is thought to signal a significant favorable turning point.

I believe one of the strongest“all-clear” signals is my Market Timing Indicator, a signal similar to the “golden cross”. It’s weakness, however, is that while investors wait for the “all-clear” signal indicating reduced market risk, significant opportunity gains are left on the table. Particularly frustrating is the fact that the steeper and faster the decline, the greater the bounce needed to turn the moving averages around. Here is the current situation (click on image to enlarge):

These are straight-line extrapolations from last nights close. It’s interesting to note that what the Market Timing Indicator looks for (based on experience back to 1963) is the Index crossing above its 180-day moving average. The larger and faster the gains (i.e., the greater the market recovery rate in the above table), the sooner the signal and at a higher level (because of the lag in the 180-day average drifting down towards it). The smaller and slower the recovery, the longer until the “all-clear” but at a lower level in the Index.

Use the chart below to do your own extrapolation:

We’re in the very earliest stages of the recovery (or so we hope). Our objective in this transitional phase between Bear and a new Bull market is not losing any of the advantage gained by being out of the market during the previous crash. My strategy is to stick to the S&P Index etf (SPY) our portfolio mimic’s the Index intself – until the transition is resolved, one way or another. If a bull is confirmed by the “all-clear”, we can aggressively buy the market’s new momentum leaders.

There’s nothing to indicate that we’ve seen the bottom (low point). If a test of the Bear market low fails, the relative performance of our portfolio won’t lose previous advantage as it declines. It’s much easier focusing on one stock (the etf) and selling it if necessary to move back into cash than having taken the time to assemble a portfolio of individual stocks which are harder to dispose for both psychological and tactical reasons like needing to pick more decision points.

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