Four Reasons To Believe In A Bottom
When I originally penned this piece on Monday night, after informally polling most of my contacts and asking them if they thought last Monday was the bottom, the response was almost universally "no." (65% of the respondents to a "Fast Money" poll on CNBC said the same thing.)
I wrote on my blog on Monday that I thought it was likely we had seen the lows. Still, I wanted to see how the market fared on Tuesday, so I held off submitting my column. I never thought Tuesday would see such a huge rally, but it just reinforces my view.
Doug Kass had a good piece on Tuesday about his lunch with "Greg from Mega". The points he raised resonated with me, but they were almost all of the valuation variety. They speak to how cheap the market is on a host of measures of both relative and absolute valuation.
I follow many of these valuation models, and they have been flashing undervaluation for some time now. But they are not great timing tools. And when the markets get this bad, many fundamentalists go to the charts.
The technicals often do a better job of highlighting bottoms, even though you never truly know without hindsight. That said, I think that the odds are high that Monday marked the lows for this bear market. I had been looking for the S&P 500 Index to test 1250 as a reasonable area to bottom, and Monday saw the SPX touch 1256. This is close enough for government work.
Also, last Tuesday we saw a 90% up day (90% advancing stocks & 90% upside volume). Along with the 3% rally in the S&P that day, this was only the fourth time in the last 28 years that we saw this combination.
And the last three occurrences were all significant market bottoms, including August 1982 and October 1987 (according to Merrill Lynch). Last, although the SPX breached its January lows, we saw the number of new lows on the NYSE contract meaningfully -- a positive divergence.
So the technical setup looks solid to me, but do we have enough extreme bearish sentiment to solidify a bottom?
Again, as a timing tool, sentiment does a pretty decent job, but it's not great. This is because negative sentiment takes a while to build, but if you look back at any major market bottom in financial history, you will see that bearish sentiment always hits extreme levels. I saw that last Monday.
The 10-day CBOE put/call ratio hit 1.27, the third-highest reading since 1995 (as far back as my data goes). The 10-day ISE Sentiment Index hit 80 (put/call equivalent of 1.25), its lowest reading since the inception of this index. So bearish investors have been loading up on put options as the market bottomed, and these negative bets could provide upside fuel for the market as they get unwound.
The investor surveys show even more bearishness. The Investors Intelligence survey showed the most bears (43%) since 1998, more than at any time during the bear market of 2000-02. And that low in 1998 was so bad that even our own Jim Cramer penned a piece that said "Get Out!" For its part, the AAII survey showed the most bears (59%) since 1990. That's pretty incredible.
And the volatility index (VIX) also showed its usual pattern. The VIX nearly reached 36 on Monday and closed at one of its highest levels since 2002. Then on Tuesday's rally, it plunged 20%. This action looks like a peak in volatility, which would coincide well with a bottom in the overall market. So I think sentiment is lined up well to support the technical action, as well as the notion of a bottom here.
I heard a lot of people saying that Monday's action didn't represent the type of capitulation lows that often mark significant bottoms. But the flip side of this argument is that when investors are braced for a cataclysmic session, and the market acts in the opposite fashion to expectations, maybe it is speaking just as loudly. Heck, on Sunday night, Hong Kong was down 1,000 points and CNBC changed its schedule to cover the Asian markets (and U.S. futures) for three hours Sunday night. Talk about getting everyone worked up into a frenzy.
So the collapse of Bear Stearns (BSC) over the weekend should have resulted in a horrendous session on Monday. Instead, the market bottomed early, and the Dow actually reversed and finished in positive territory. If the collapse of the fifth-largest investment bank can't take the SPX below 1250, I think it is unlikely that future events will be able to do so, even though there may be more negative headlines to unfold.
Bear markets are often punctuated by a major financial crisis that occurs right at the lows. I thought that Countrywide (CFC) being taken under for roughly $7 might be the example this time around, but the Bear Stearns saga fits the bill even better. History will likely dump this event of market lore into the same category as Penn Central in 1970, Continental Illinois in 1984, Citibank in 1990, and LTCM in 1998. And all of those events marked significant bottoms. According to Merrill Lynch, the average return for the SPX in the 12 months following these events was +17.3%. Not bad.
The mantra "Don't Fight the Fed" exists for a reason, and I think it has now kicked in. The Fed has injected huge liquidity into the market and put in place ample loan programs to provide a backstop for financial institutions to prevent further bank runs. This is huge, and when the Fed says, "I've got your back," you should probably cover your short positions.
I am not advocating a "V" bottom here, because I don't think the market will run away on the upside. There is lots of overhead resistance ahead of us, and it will take time for the market to work its way out of this morass. We could be in a multimonth trading-range market, which would still be preferable to the last five months. But I think we will look back at the "Bear Stearns Bottom" as the lows for this period, even if they are tested soon.