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If We Aren’t Near A Bottom, Find A Cave & Buy Guns at Trader’s Narrative

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What an inauspicious anniversary. It is a year since the Dow closed at its all time high - it is now trading down about 35% from that level. While I don’t think we are going to go straight up if things do stabilize, there is enough shrill panic out there to make me think that we should be close to a floor. If we aren’t, then all bets are off and I suggest we all flee to the hills. This isn’t based on mere “gut feeling” but on metrics and indicators that have been faithful guides historically.

So here are some observations:

Global Meltdown
There is enough pain for every single market out there. Forget banning short selling, Iceland outright suspended trading altogether. Indonesia halted trading after a 10% plunge. Russia has seen an utter collapse of their market. Same thing with China’s equity bubble. England has taken equity stakes in financial institutions while other European countries struggle to find a solution. There is a blanket of fear and panic covering the world to a degree that we haven’t seen in a very long time.

Credit Squeeze Easing
The first hints that we could finally be seeing a loosening up of the tight credit markets are here. The spread between the rate for the 2 year interest rate swaps and Treasury yields seems to have formed a double top at 167 on September 29th and October 2nd 2008. At its top, the spread was the widest since data has been collected (going back to 1988). This is a signal of easing for the LIBOR rate but the bad news is that LIBOR and TED spread haven’t responded by falling yet. But this may be the first inkling that they are about to.

Sheer Disgust & Panic
Finally, we can say that there is extremely negative sentiment out there. Both from everyday investors and traders, to newsletter editors. The option metrics are still not “cooperating” by showing extreme put buying. Which is something that I’ve mentioned before. It is still very puzzling to me. But the other traditional measures of sentiment show that the vast majority have thrown in the towel and believe that we will see further declines. From a contrarian point of view, this is a good thing. I’ll go into more detail in tomorrow’s sentiment overview.

How Bad Is It?
Things are so bad that, of the 500 stocks in the S&P 500 Index, only 6 closed trading yesterday above their 50 day moving average. And only 4.2% are trading above their long term, 200 day moving average. For the Dow, all 30 stocks are trading below both of the moving averages.

percent spx above 50 MA october 2008

Horrendous Breadth
For both the Nasdaq and the NYSE, about 50% of stocks have registered at new 52 week lows. This means that the pain is across the board. On the plus side, when the market internals have gotten this horrible in the past, we’ve seen it as a sign of selling exhaustion. I already outlined the distance of the market from its 200 day moving average, yet another sign that we are overly stretched to the downside.

nasdaq high low ratio long term chart oct 2008

We are actually way below what we saw at the bottom of the 2002 bear market. This atrocious breadth has pushed the Nasdaq (Ratio Adjusted) McClellan Oscillator off the chart from a historical perspective.

Financial Sector… Finally
I’ve been waiting for this with trepidation. Although the financial sector has been the hardest hit, having fallen almost 50% from last year’s high, the bullish percent index of the sector had been abnormally high… until recently. This is the first sign of capitulation for a sector that has been in the eye of the storm.

bullish percent financial sector long term chart October 2008

It may be hard to see the right edge of the chart but I wanted to show this index going back all the way to 1998, including the financial crisis then. We don’t have very many comparisons for what we have seen recently. The 1998 experience is still the closest in modern history and we are now seeing the bullish percent index for the financial sector reach the same threshold it did back then.

I’m not suggesting that anyone step into this market whole hog. But I think definitely we are much too late into this to start selling or to short now. In order to truly be able to say that we are seeing a floor we need to see the market give confirmation. We aren’t there yet. But we are getting close to a waterfall decline that will completely wash out selling pressure and set the stage for that to happen.

The big tell on this will be tomorrow’s Lehman Bros. derivatives garage sale auction. The market tone will depending on how the market reacts. The next big hurdle will be Washington Mutual’s auction on October 23rd.

For a different take on things, watch this video from Fast Money at CNBC:

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4 Responses to “If We Aren’t Near A Bottom, Find A Cave & Buy Guns”  

  1. 1 Tony

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    Hi Babak,

    You bring some good points about the bullish case for stocks.

    The thing that concerns me is the current COT report on the S&P 500 and other major indices. The commercial hedgers seem to be getting more net short on the S&P 500 along with the other indices.

    Any thoughts on this?


  2. 2 Babak

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    Tony, that’s a good point. To be honest, it is something which I’ve mentioned many times on the blog but not lately because it seems that it is losing its power as an indicator. Perhaps it is due to alternative derivatives which are substituting futures positions (think swaps). Whatever the case, while I don’t want to dismiss it outright, the weight of the evidence convinces me more than any one single one.

  3. 3 Dave M.

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    I have followed the COT report on the S&P 500 (commercial hedgers category) for many decades and have used it quite successfully over those years. This indicator used to work really, really well and I made a ton of money on it. However, it stopped working in 2003 and is now useless. What a shame.

  4. 4 Babak

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    yeah, that’s what I thought too Dave. Why do you think that happened? did too many rely on it? or was it something else?

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