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The ferocity of the stock market decline in the month of August (which proved once again that modern day politicians can take any situation and make it far worse) took many investors by surprise (Hi, my name is Jay). And as is the case with all market declines, the big question is “buying opportunity or the start of something worse?” And as is also the case, if you scan the world of market punditry you can easily find someone to tell you exactly what you want to hear. In other words, if you want to believe that the latest decline is a buying opportunity then you can easily find a “highly regarded” analyst to tell you exactly that. Likewise, if you find yourself in a “darker mood” and are of the opinion that things are going to get far worse, it is no problem to find someone to “confirm” your own thinking.
One Perspective
I have no problem buying the notion that “things” can get much worse. The fact that we (and ironically, when I say “we” I do not mean you and/or I specifically) have taken on more debt than we can realistically hope to pay back suggests that at this point “our way of life” (and sadly when I say “our” way of life, I do mean you and/or I) is in grave danger. Still, I feel I’ve done enough of the gloom and doom stuff of late, so let’s take a look at the brighter side. Call me crazy (OK, first take a number), but I still think that the stock market can stand at sharply higher ground 6 to 12 months from now.
First the Bad News (Part 1)
August, September and October represent something of a “Stock Market Bermuda Triangle.” Measured since the end of 1933, the Dow Jones Industrials Average has actually lost ground during the months of August and September. In addition, while the Dow has shown a net gain during the month of October, it still remains known as “the month of the Crash” – with good reason.
Numerous sharp market declines have taken place during the month of October. Two worth mentioning are Black Monday in 1987 and the financial meltdown in 2008. Figure 1 displays the “growth” of $1,000 invested in the Dow only during the months of August, September and October since 1933.
Figure 1 - Decline of $1,000 invested in the Dow only during Aug-Sep-Oct since 1933
click to enlarge
As you can see it is not as though the stock market relentlessly loses ground during this three month period each and every year. But the long-term results suggests that this is not typically the best time to be a rip-roaring bull.
First the Bad News (Part 2)
Another cause for concern is the typical nature of market bottoms in general. In the majority of cases following a sharp market decline, the major averages do not reverse to the upside and never look back – although there are exceptions to the rule. In most cases, the market:
-Experiences a frightening decline
-Rallies, thus causing many investors to breathe a sigh of relief
-Then spends the next several weeks or months swooping and soaring in a violent manner, ultimately wearing out many investors and ultimately prompting them to sell at exactly the wrong time.
Figure 2 displays four different market bottoms using the Dow Jones Industrials Average. In each case, the market suffered an initial plunge and then spent the next several months groping for a bottom.
Figure 2 – Market bottoms often take time to form
click to enlarge
As we will see in a moment, the stock market reached an extremely oversold level on a historical basis during the month of August. This argues that there may not be a lot of remaining downside risk on a percentage basis. However, the history displayed in Figures 1 and 2 suggest that it may take a while for the final bottom to form.
The Good News
The “good news” was actually “bad news” while it was in the process of becoming good news. Huh? Here’s what this means. The stock market reached an extremely oversold level during the month of August. Typically this type of washout sets the stage for the next major advance. So the good news is that we’ve had the washout. The bad news is that a lot of investors lost a lot of money in the process. But now that that is out of the way (with the caveat mentioned above that things could remain quite volatile for a while), let’s review just how oversold things got in recent weeks.
Figure 3 displays and overbought/oversold oscillator I follow that combines a number of measures including the VIX Index, the put/call ratio, TRIN, advances versus declines and the McClellan Oscillator.
Figure 3 – Jay’s Overbought/Oversold Oscillator near record oversold territory
(note position of blue line at far right)
click to enlarge
This oscillator – which gets more negative as the market gets more oversold - has now fallen to a level that has only been reached or exceeded a handful of times including October 1998, October and November of 2009 and May and June of 2010. Each of these periods led to meaningful market lows and was ultimately followed by strong advances.
Figure 4 displays another oscillator I call the PCVXO Index that measures:
-The VIX 10-day average divided by the VIX 65-day average
-The put/call ratio 10-day average divided by the put/call 65-day average
-Then takes the average of the previous two measures (x 100)
As you can see in Figure 4 when this oscillator “spikes” to sharply higher levels it tends to coincide with meaningful market bottoms. This oscillator also reached an extremely oversold level in the past week.
Figure 4 – Jay’s PCVXO Index “spikes” sharply
(spikes suggest buying opportunities) above 1.40
(note blue line at far right)
click to enlarge
So when does it all turn around and start the next big advance? While that question is impossible to answer definitively, one thing to keep an eye on is the number of new highs and new lows. The red line in Figure 5 is calculated as follows:
A = Nasdaq daily new 52-week highs
B = Nasdaq daily new 52-week highs
C = A / (A + B)
D = 10-day moving average of C
In other words, each day we divide the number of NASDAQ stocks making new highs by the number of NASDAQ stocks making new highs or new lows (can range from 0 to 1). Then we take a 10-day moving average of the daily readings.
Figure 5 – Red line = 10-day average of Nasdaq new highs / Nasdaq new highs plus Nadaq new lows (1988-present)
click to enlarge
Very often a rise by the 10-day average from below 0.20 to above 0.20 signals that the decline is over and that momentum is turning the corner. As of 8/16 the 10-day average stood at 0.094. So we need to look for this value to get back above 0.20 to generate a positive signal.
Summary
The financial markets are always something of a puzzle. Attempting to predict each twist and turn is interesting but ultimately impossible to achieve. Nevertheless, in a nutshell, Ying follows Yang, i.e., the market gets deeply oversold, and then eventually it rallies. Our job as investors is to:
-Recognize when the market is oversold (see Figures 3, 4 and 5 above)
-Assess the likelihood that most of the damage is done and that the market will soon turn the corner
I think there is a very good chance that the August selloff will ultimately be viewed as a useful buying opportunity. That being said, between now and the end of October there is likely to be a lot of volatility as the market experiences several fits and starts as it tries to build a meaningful bottom. When the market rallies sharply the headlines will cause many to “breathe a sigh of relief” and pile back in. When the market subsequently plunges again another wave of investors will “throw in the towel.”
The key then is ignore the headlines, look for good candidates – be they individual stocks, mutual funds or ETFs – and watch for a double or triple bottom to form and/or for our 10-day Hi Lo index (see Figure 5) to rise back above 0.20).
To paraphrase whatever urban philosopher said it first, “patience, er, people, patience.”
Jay Kaeppel
Optionetics.com
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