Wednesday, July 9, 2008

Psychology of a bottom without fear

It's hard to find a blogger who is not talking about the possibility of a bottom in this market. Some have taken an interesting spin on things; Bill Luby has an interesting study on the relationship between Financials and Oil ETFs; Headline charts had good things to say about Investors Business Daily's Big Picture as a marker for a bottom; Even Barry Ritholtz has talked about a pending bounce, but would like to see more fear in the market.

Tuesday's gains were a start, but not everyone has expressed joy at the bounce; Quantifiable Edge was disappointed with the gains in the S&P, after early optimism. While the Chartswingtrader noted the presence of nearby resistance for the markets as oil prices approach a support level.

The lack of fear as measured by volatility (VXN and VIX) should be a concern. Not everyone is letting the VIX off the hook. Sean Hannon at Stocktradingtogo has noted the lack of extreme in volatility.

The VIX currently trades near 26. While this is high in relation to where it traded before the selloff began in mid-May, it is below where prior reversals have occurred. When the market temporarily bottomed in January and March, the VIX spiked above 30 and quickly reversed. During these spikes in January and March, the VIX traded nearly 10 points above its 10 day moving average (MA) and nearly 15 points above its 200 day MA. Today, the VIX is 2 points over its 10 day MA and 3 points above its 200 day MA. While fear has increased in the market, it has not reached the point of capitulation we would expect from major market bottoms.

Chartswingtrader was similarly disappointed with VIX action:

One of the reasons I am hesitant to think today's action was anything more than a one or two day event is the VIX continues to go nowhere. Everyone mentions this, but it is true. We haven't approached any of the levels for the past four bottoms put in over the past year, and I have a hard time believing an intermediate-term bottom in a major bear market is going to be put in with a VIX around 25. We'll see - it could happen, but it would be quite unusual.

Is there a historical precedent to current action?

Because many of the breadth indicators which measure market momentum today only came into existence over the last 10 years there is a relatively small pool of data to work with. The closest one gets to a situation when oversold breadth indicators did not mark an immediate bottom was 1998.

The NYSE/S&P and Nasdaq breadth indicators tell tales which should be heeded today. In the case of the NYSE/S&P the first hint of a bottom emerged in August. The S&P had rolled from 1,188 down to 1,068 in the space of a month, bringing the Summation index to -1,000 (lower than where it is now) and spiking volatility (VIX) into the low 30s. Volatility had risen steadily from 16s to 30s over the course of the decline (not even close today at 23.15) so there was a rise in fear in the market - but nothing to suggest a capitulation.

The index struggled at its 50-day MA before breaking support; trapping bulls and spiking fear, raising the VIX into the 40s:

It was only then that the S&P worked on a bottom. By the time of the retest in October the breadth of the market had improved markedly as fear remained high (VIX in the 40s, but the Summation Index was well on its way to inspiring a rally).

The same picture played out in the Nasdaq. The main exception was the sharp advance in fear on the retest of the bottom in October as the Nasdaq sloughed off another 20%:

Again, there was a situation of a reversal candlestick pair in August which appeared with an oversold Summation Index and a volatility reading of 38, which at the time probably looked like a spike. Matched with today's values (Summation at -996 and VXN at 28.43) there is little to suggest we have gone as low as we can.

The positives for the current picture is neither index is trading close to its 50-day MA (or indeed its 20-day MA), so markets have already sold off harder than they had in August 1998. The Nasdaq eventually went to lose 30% and the S&P 22% from its July highs to October lows in 1998; in 2008 the Nasdaq has already shed 25% to its March lows and the S&P is down 21% currently - so each are probably very close to their true bottom. From a buying perspective, whether you bought in August 1998 or October 1998 didn't matter too much as what followed was one of the strongest rallies in recent memory.

Why sweat a bottom? If you have money to invest simply split it up into 3-5 lots and buy your favorite stock or index ETF piecemeal at regular intervals over the coming months or weeks. Down the road your average buy-in should reap dividends.

Dr. Declan Fallon, Senior Market Technician, the free stock alerts, market alerts, and stock charts website