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Here are some thoughts with my own conclusions at the end:
Ned Davis Research
A very respected institutional research house, Ned Davis’ company relies on 12 indicators covering sentiment, volume, volatility, and breadth. Right now ten are flashing a cyclical buy signal. But a unanimous result isn’t needed for it to be valid. For example, in the bear market bottom of 2002, only nine of Ned Davis Research’s indicators was indicating a buy. But they are not recommending to their institutional clients to start buying. They want to be patient and wait for a retest of the lows. If market internals are healthy on such a retest, then they would suggest going long.
Stock Market Cycle
There are patterns in the market’s history. But so far this year, the market has forged its own path. An election year should be a positive for market returns, especially in the later months of the year. But not this year.
The four year stock market cycle means that 2010 is the year to watch. But according to the decennial cycle, the 8th year in a decade has been good historically. Unless we have a miracle, this year will also be an exception. Here is the master of market cycles, Peter Eliades offering his views:
Credit Squeeze Relaxing
Both the TED spread and the LIBOR rate have receded. As well the price of “insurance” on default for banks has also dropped. There are mounting signs that we are seeing a thaw in the credit freeze that paralyzed the market. My only quibble is the short term rate (90 T-Bill rate) which continues to be pushed down. The bond market is telling the Fed to lower rates. Hopefully they will listen (unlike all the previous times) and get ahead of the situation rather than playing catch up.
Volatility has been absolutely insane. There is no gentler way to put it. We’re seeing double digit (or close) moves in the market daily. It is both unnerving and exciting. And here I’m not just referring to the sky high VIX index but also to the breadth numbers which show extremes. The good news may be that such volatility has been historically associated with market bottoms. As I wrote two years ago, extremes in market breadth with the advance decline numbers swinging from one extreme to the other to gather “fuel” for a sustainable trend to be established:
Smart Money vs. Dumb Money
At every inflection point in the market, we witness the smart money and the dumb money do different things. This is how wealth is transferred from one group to the other after all. So far we’ve seen Warren Buffett extract very favorable terms with General Electric (GE) and Goldman Sachs (GS). Terms that the US government hasn’t gotten. That’s another issue though. Although you or I may not be able to negotiate the same terms, it is still valuable to watch what the smart money is doing.
Corporate insiders are also considered “smart money” and they have accelerated the rate of their purchases, pushing the buy-sell ratio to 2:1. This is very unusual because usually it is the other way around as insiders sell shares which are given to them as part of their compensation package. But caution is warranted because insiders are notorious for being early to the party - as much as one whole year.
The other end of this see saw is to watch the “dumb money”. I’ve gone into detail over the past sentiment overview regarding the public’s and retail investor’s pessimism during this crisis so I won’t rehash it here. Now that we are getting the first glimpses of the bulls returning, the most important aspect of contrarian sentiment comes into play; watching how the “dumb money” reacts to a recovery in the markets. If they continue to be fearful and pessimistic, even when the market recovers, then the chance that it is a real floor is much higher. But if they quickly switch sides, then we will see more downside.
My own hunch based on all of the above and more, is that this is a cyclical bottom. It is tradeable, and the volatility provides amazing short term opportunities for trigger happy traders but we are far from a secular bottom. You’ll know we’ve hit that when stocks and the whole equity culture of the US and the world changes. When people start outright hating stocks or even the thought of investing.
When everyone laughs at you or feels sorry for you for even hinting that it may be time get back in the stock market. When the valuation pendulum swings way to the other side and measures, whether based on price earnings or price dividend are so outlandishly extreme that you do a double take. That’s when you’ll know we’ve hit a secular bottom. One for generations.
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