Discussion of market bottoming potential, courtesy of Alan Brochstein at AB Analytical Services. 
How Oversold We Truly Are
I would certainly not like to be known as the "Sponge Bob" of bottom calling (how about now, what about now?) – it isn’t a fun game in these markets. I was oh-so-negative in the summer of 2007 and ecstatic with the declines in January and March, when I was still short. But, I changed teams early. Quite frankly, I was able to navigate the long side well, as the types of stocks in which I was investing proved to perform quite well despite the pressures on the market, even into the end of Q3 (just 11 very long days ago). In late September, I shared my views regarding "the bottom" being near if not even behind us. While I may have been right if one assumes I meant in time but not price (God help us if not!), I, like anyone else who was long any stock, have had my proverbial hat handed to me, stuffed down my throat and et cetera. It hasn’t felt good – that hat was a hard one. A long-only portfolio that I manage was actually up 1% YTD through quarter-end, but now is down a whopping 17%. I guess that’s not so bad relative to the market, but it’s very bad.
What now? While most of the elements that were signalling a potential bottom are still present (to an even greater degree, obviously), I still can’t be more confident than I was then (which was more hopeful than declatory) despite the plunge in prices. As a reminder, here is what I was looking at:
***The right solutions are in the public domain now
We can certainly take off the "confirmed rally" – it quickly failed (as I pointed out might be the case). For the most part, though, all of these indicators have become more pessimistic (which is positive). One aspect that I didn’t include two weeks ago was the level of "oversold". There are many ways to measure it, and, no matter how one looks at it, suffice it to say that a record drop in a week from already oversold levels leaves the market extremely oversold. As we have seen, this is no guarantee that it can’t fall further or become even more "oversold". With that said, I wanted to share an indicator that I use: The number of stocks above their 50dma. The S&P 500 has just 3 (less than 1%): CME, JPM and UST. I guess it could go to zero, but this level is unheard of. Perhaps the guys at Bespoke can look into the statistic as it pertains to post-9/11 or the lows in 2002. In the S&P 400 (Mid-Cap), there are 6 (1.5%), including a tech stock, a retailer and four financials. In the S&P 600 (Small-Cap), there are 12 (2%), including a home-builder, a drugstore being acquired for cash, a food distributor, 7 financials and 2 tech stocks.
Bear markets wipe out typically 1/2 of the previous bull market, but, as measured by the S&P 500 from its close Friday, we have retraced 84%. Of course, this isn’t just in our country but in all of the major economies. Anyone who can confidently say that things can’t get a lot worse is most likely fooling himself or herself. Just as one can’t tell how far the pendulum will swing to the upside, it is impossible to estimate the overshoot downward. Traditionally, lower prices bring in buyers, but, in a deleveraging world, they bring in more sellers. It is this process that has caused the traditional measures of sentiment and volatility to improperly signal a potential bottom. I certainly don’t know how much worse it can get in the short-term. And isn’t it funny how when the short-term is so disastrous that the focus shifts from the long-term? After all, if you can’t survive the short-term, who cares about the long-term? I remain hopeful that stocks, which tend to be a forward-looking discounting mechanism, have over-reacted, but I sure have no real inside information there.
To me, this market feels a lot like the Oil market a few months ago. You may recall that the day oil peaked, it gapped up in the morning, climbing inexplicably yet again. It was what is known as an "exhaustion gap", where it gapped up to an all-time high and then never saw that level again. We are down almost 50% in a short period of time since then. What we didn’t know that morning was that there was a collapse of a gigantic speculative trade, with a massive short-covering. Well, I am not so sure that Friday was the final low for stocks (obviously), but it had many of the markings, as the lows on that gap down from the open served as the bottom for the day. We know that there are many, many investors being forced to sell. What will we learn in the days ahead? How many Aubrey McClendons are there (CHK founder who lost almost his entire stake due to a margin call)? We know that the market will eventually rebound. Anyone who has bet on it recently, though, is hesitant to make that bet again. So, only a few will be able to buy "the" bottom. But that isn’t the goal.
Long-term investors know that this meltdown creates an opportunity whether they buy the S&P 500 at the intraday low of 840, the closing price of 899, tomorrow’s price of 750 (I hope not), or even next week’s price of 1000 (hypothetically). The important thing is to have confidence that the bottom is behind or at least be willing to suffer until then. So, with great care and humility, I will continue to search for compelling signs that the market has bottomed, though I know that it could prove to be false yet again. Unfortunately, it’s anyone’s guess at this time.
Disclosure: No position in any stock mentioned
