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How to spot the next market bottom

Summary:
RealMoney columnist Helene Meisler asked rhetorically in an article where her readers thought we are in the equity sentiment cycle. She concluded that the market is in the “subtle warning” phase, though she would allow that the “overt warning” phase was also possible.  I agree. This retreat is acting like the start of a major pullback. The S&P 500 recently violated its 50 day moving average (dma). Past major pullbacks that began with 50 dma breaks were marked by the percent of S&P 500 bullish on point and figure charts plunging below 50%. To be sure, this does not assure us of a significant downturn, though it represents a sufficient though not necessary condition for one.  Two weeks ago, I discussed the magnitude of market weakness (see How far can the market fall?), with the

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RealMoney columnist Helene Meisler asked rhetorically in an article where her readers thought we are in the equity sentiment cycle. She concluded that the market is in the “subtle warning” phase, though she would allow that the “overt warning” phase was also possible.
 

How to spot the next market bottom

I agree. This retreat is acting like the start of a major pullback. The S&P 500 recently violated its 50 day moving average (dma). Past major pullbacks that began with 50 dma breaks were marked by the percent of S&P 500 bullish on point and figure charts plunging below 50%. To be sure, this does not assure us of a significant downturn, though it represents a sufficient though not necessary condition for one.
 

How to spot the next market bottom

Two weeks ago, I discussed the magnitude of market weakness (see How far can the market fall?), with the caveat that those were not targets, but estimates of downside potential. This week, I outline some techniques on how to spot a market bottom.
 

The retreat is only starting

Evidence is gathering that the market weakness is only starting. From a top-down perspective, the Citigroup US Economic Surprise Index, which measures whether economic data is beating or missing expectations, has topped out and it is rolling over.
 

How to spot the next market bottom

JPMorgan equity strategists pointed out that earnings estimates, are also weakening after peaking out, especially in the US.
 

How to spot the next market bottom

BoA reported that its private client holdings survey of cyclical optimism has peaked out and weakening.
 

How to spot the next market bottom

Equally worrisome is the strength of the USD Index. The USD has been inversely correlated with the S&P 500 since the March low. Moreover, the AUDJPY exchange rate, which is another key foreign exchange risk appetite indicator, is weakening.
 

How to spot the next market bottom

Arguably, USD strength is a sign that the market is growing concerned about the waning growth outlook. In addition, the appearance of a second pandemic wave in Europe has created doubts about the durability of a global cyclical rebound. Consequently, gold prices, which tend to be inversely correlated to the USD, have retreated below an important resistance turned support level, and the inflation expectations ETF was rejected at a falling trend line.
 

How to spot the next market bottom

The market appears to be setting up for a prolonged period of heightened volatility. My survey of SPY at-the-money option pricing shows that implied volatility remains high and peaks out in mid-December, which is well after the election.
 

How to spot the next market bottom

With Joe Biden ahead in the polls, the market is positioning for a loss by the incumbent, though we may get more clarity after next week’s debate. While the economy is not the only variable that affect voter intentions, this JPMorgan analysis shows a correlation between Trump support and employment levels, with key swing states highlighted. As the cyclical outlook weakens, this will creates headwinds for Trump.
 

How to spot the next market bottom

Ed Clissold of Ned Davis Research reported that incumbent Republican losses have historically been unfriendly to equity prices.
 

How to spot the next market bottom

In the year after the election, the stock market has historically not bottomed out until early March in years when the incumbent Republican loses the White House.
 

How to spot the next market bottom

As the large cap NASDAQ leadership breaks down after a terrific run, investors are reminded to heed the following Bob Farrell’s Rules of Investing:

  • Rule #2: “Excesses in one direction will lead to an opposite excess in the other direction”; and
  • Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”.
How to spot the next market bottom

The combination of technical breakdowns in large cap NASDAQ stocks, retreating cross-asset risk appetite, and nervousness over the election is setting up for a significant drawdown in equity prices over the next few weeks and months.
 

Spotting the market bottom

With that preface, here are some signposts of a durable market bottom. These are intermediate term timing indicators. They will not pinpoint the precise bottom, but they will identify attractive levels to be buying. I don’t expect that they will all flash buy signals simultaneously, but a majority should be bullish at a market bottom.

The first is insider buying. This group of “smart investors” have tended to be relatively prescient at market bottoms, though they can be early. Normally, insider selling swamps buying activity. I would look for clusters of insider buying that exceed selling.
 

How to spot the next market bottom

The one caveat about insider activity signals is they are not precise market timing indicators. Insiders were early at the bottom in 2008-09, and they began buying in late 2008 ahead of the final bottom in March 2009.
 

How to spot the next market bottom

Where are we now? There are no signs of feverish insider buying. Instead, Bloomberg reported a flood of insider sales.

Corporate executives and officers at S&P 500 companies were busy unloading shares of their own firms over the last four weeks. The selling picked up so much versus buying that a measure of insider velocity tracked by Sundial Capital Research pointed to the fastest exit from stocks since 2012.

How to spot the next market bottom

The second class of bottom spotting indicators is investor sentiment. Sentiment surveys, such as Investors Intelligence, have generally not recycled to a bearish extreme. While the recent decline in bullishness is constructive, I would like to see bearish sentiment soar. In the past, durable market bottoms have not been formed without a spike in bearishness.
 

How to spot the next market bottom

Lastly, I am also watching for signs of an intermediate term oversold extrme. In the past, the combination of an oversold condition in the Zweig Breadth Thrust Indicator (ZBT) and a negative reading in the NYSE McClellan Summation Index (NYSI) has been reasonably a good signal of an intermediate term bottom. Technical purists will recoil at my use of the ZBT Indicator in a non-traditional fashion. Marty Zweig’s original ZBT buy signal looked for a breadth thrust, defined as an oversold condition on the ZBT Indicator, followed by an overbought signal within 10 trading days. Breadth thrusts are extremely rare, but ZBT oversold signals are not. The combination of a ZBT oversold condition and a NYSI negative reading can be good gauges of an intermediate term oversold market, with the caveat that this signal was early during the March decline and flashed a buy signal about halfway through the pullback.
 

How to spot the next market bottom

This indicator appears to be nearing a buy signal, but appearances can be deceiving. StockCharts reports the ZBT Indicator with a one-day delay, and I have created my own real-time estimate. Friday’s market rally lifted the ZBT Indicator off the oversold level. The ZBT Indicator is no longer oversold.
 

How to spot the next market bottom

From a breadth thrust perspective, Friday is day one, and the market has nine more trading days to achieve a ZBT buy signal. I am not holding my breath.
 

An orderly decline

So where does that leave us today? So far, the market’s decline has been an orderly affair. Even though the S&P 500 is off about -10% off its highs in less than a month, there have been no signs of investor panic. The CBOE put/call ratio is still relatively low, indicating continued bullishness. In addition, there have been few TRIN spikes over 2, which are often indicative of price insensitive panic “margin clerk” selling that often occur at the end of major price declines.
 

How to spot the next market bottom

Barring a significant fundamental turnaround, investors should be prepared for further stock market weakness. I would monitor the combination of insider trading, investor sentiment, and market technical conditions for signs of an intermediate term bottom.

We are not there yet.
 

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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