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Record Stock Market Volatility Signals Bottom at Trader’s Narrative

Every trader prays for volatility because without it, prices wouldn’t move and there would be no chance to make a profit. But too much volatility can be as deadly as a quiet market. It would be a crass understatement to say that we are experiencing tremendous volatility these past few weeks.

The stock market has been either going up or down by at least 1%, for more than 70% of the trading sessions these past three weeks. This amount of volatility is both extreme and rare.

While stop losses are getting hit all over the place, the good news is that this level of volatility has a good track record of signaling important market bottoms.

A good measure of price volatility is the technical indicator known as “Average True Range” - developed by Welles Wilder in his 1978 classic: New Concepts in Technical Trading Systems.

atr spx500 2000 to 2008

As you can see in the chart for the S&P 500, the average true range is as high as it has been since 2002 (yet another indicator hitting these chronological extremes).

In case the graph is too small to see, the 2000 signal was for the mid April 2000 “mini-crash”. On a chart like this one, the fall and snapback rally may seem insignificant, but if you were there during those days, you would remember the harrowing experience.

And since I haven’t been featuring the venerable Dow Jones enough, here’s a chart for it showing similar signals:

atr dow jones 2000 to 2008

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10 Responses to “Record Stock Market Volatility Signals Bottom”  

  1. 1 wes

    Only a very few widely followed indicators HAVE NOT signaled a bottom. If the market undercuts recent lows, I suggest we concentrate on those few indicators that have, at least so far, gotten it right.

    Among the few indicators that have not signaled a bottom are the Rydex ratio, Investors Intelligence, the smart money index and the OEX put/call ratio. Babak, perhaps you know of some others and could list them.

  2. 2 Babak

    wes, afaik the Rydex data and OEX options have reached critical. We’ll never have all the indicators line up in synch - what matters is the overall picture.

    btw, what’s the smart money index?

  3. 3 wes

    Babak, I know all the indicators will never line up in synch. My point was that, if the market undercuts recent lows, all of the indicators that have given buy signals will have been shown to be WRONG, or at best, early (which in most cases is just another way to say wrong).

    Conversely, those indicators that so far haven’t given a buy signal will have been shown to be correct. So why not look just at those so far correct few for the REAL buy signal, ignoring all of the wrong indicators?

    The Rydex ratio, which is a measure of sentiment, has consistently shown a greater bullish bias than at the August low, an even greater bullish bias than at the March low, and a much greater bullish bias than at the 2006 lows. Now this sentiment as reflected by Rydex, is not simply what one thinks of the market as expressed by a bull/bear opinion, but it is how a large population of retail investors (supposedly dumb money) are actually invested.

    Similarly, the investors intelligence numbers and the OEX option players (smart money) are out of whack for calling a low. The smart money index has shown consistent selling by the smart players until just recently, and remains well below previous readings at market lows. (more on this below).

  4. 4 wes

    The smart money index was developed in 1987 by a Lynn Elgert and was published in a Barrons article following the 1987 crash.

    I don’t know it’s exact construction, but it’s based on the early morning trades being the emotional and news driven trades (dumb money) while the late afternoon trades are the more reasoned trades (smart money). It is constructed by subtracting the early morning volume (first 30 minutes using Dow volume) from the late volume (last one hour using Dow volume).

    I don’t know if any correction is made for the time periods being different, etc. In short, I’ve told you more than I really know, but I try not to let that constrain me.

    I have read that the SMI has hit a lot of home runs, calling the 87 and 98 declines. I have also read that it has a lead time of 75-85 days, so it may not be able to be used to find a market bottom.

    I am exposed to SMI through a subscription service, so I can’t provide a link. I can tell you that the SMI has been in an almost straight line decline going well back into 2006, until the past two weeks, when it has started to climb.

  5. 5 horeshoe

    horseshoe likes 11890 then 13190 Aug.

  6. 6 registered investment advisor

    There are many market signals out there and new ones are being developed. Recently, I read a journal paper that says consumer confidence can signal market turns. The overall principle should be: buy in fear and sell into euphoria. It is however very hard to carry out. That why the few who could (like Warren Buffet) are rewarded handsomely by the market.

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