This week the S&P 500 came within a whisker of retesting
the August panic low at 1,867, before rebounding yesterday to close out what
has been a dismal third-quarter for global investors.
The small-cap Russell 2000 Index actually undercut its
August low this week, but so far at least, the other major U.S. stock indexes
are holding.
The market is following a familiar pattern here, and if
history is any guide, stocks may find a bottom soon. Let's take a closer look
at the typical road map for a market bottom, and where we are now.
Stock market roadmap
There are dozens of historic examples that show stocks following
a familiar bottoming pattern that typically unfolds in three distinct phases:
Phase 1: Initial sharp panic selloff
Phase 2: Intermediate bounce higher
Phase 3: Final retest of the low — or break to new lows
Take a look at the graph below, which shows the last 20%
correction in the S&P 500 back in 2011, compared with the market today.
As you can see, the current path stocks are taking (orange
line) is closely following the 2011 pattern (blue line). In both cases we
witnessed a short but very sharp down move in August.
Next, stocks bounced higher in September, but fell short of
making new highs.
Then stocks roll over again and fall back toward a retest of
the panic lows. In fact, the S&P was down five of the past six sessions as
of Tuesday's close.
If the S&P keeps
following this roadmap, expect at the very least a retest of the 1,867 low on the S&P (and for the Dow
the low is 15,370) and perhaps an undercut of that level, leading to new lows
for stocks sometime in October to
complete the bottoming process.
That could clear the way for a fresh market uptrend into
year end. Only time will tell; just keep in mind that while history doesn't
repeat exactly, it does rhyme.
In 2011, stocks actually fell to new lows in October, which
caused many investors to sell in a panic. And once that capitulation took
place, the market reversed to the upside, gaining 30% over the next six months!
But how can you tell a true market bottom from a head fake?
While every bottom is somewhat unique, they almost always have three important
conditions in common.
Three conditions for a market bottom
#1 — Stocks get washed out: For a reliable market bottom,
you need stocks to get completely washed out. Usually this happens during a
retest of the panic low, or better yet, a lower low, as noted above.
Most investors get paralyzed with fear and throw in the
towel at that point. And you need this kind of capitulation to form a lasting
bottom.
A great indicator to keep an eye on is the number of stocks
trading below their 50-day moving averages — indicating a downtrend. In a
washed out market, you'll see 95% or more of S&P 500 stocks fall below this
key technical level and stay there for several weeks.
In the last week of August, we briefly reached this point,
but a few more weeks of extreme selling may still be needed to tell us the
majority of investors have stepped to the sidelines and there is no one left to
sell.
That's when stocks should be ready to rebound.
#2 — Pessimism runs rampant: Investors Intelligence keeps
tabs on the advice of professional stock pickers, and right now they are the
most bearish in 30 years!
In fact, the last three times bearishness sentiment ran this high — April 2009, August
2010 and October 2011 — it turned out to
be a spectacular buying opportunity for stock investors with the S&P 500 gaining 20%-plus over the next six
months.
#3 — Pros are almost always holding too much cash at
bottoms: Peter Lynch is famous for saying individuals almost always have an
edge over big institutional investors. His advice: Steer clear of the
"blundering herd," as he called them, because the Wall Street pros
are almost always wrong at important turning points.
Sure enough, institutional money managers are holding over
5.5% of assets in cash, according to a recent survey of global fund managers by
Merrill Lynch (see graph below). That's the highest allocation to cash since
2008!
Again, when the blundering herd moves high levels of cash to
the sidelines, most of the selling pressure is already exhausted, and everyone
holding cash is now a potential buyer of stocks.
Will stocks continue to follow the roadmap in 2015?
It's too soon to say that the stock market is out of the
woods just yet. The bad news is the May-August 2011 decline clipped the S&P
500 for a 19% loss, while the May-August 2015 decline was only down 12%. That's
why we could go even lower in the weeks ahead.
The good news is that while October has a scary reputation,
it has historically been a month when stocks have made important bottoms. First, I'd like to see the market show it can
hold the recent lows, accompanied by extremely negative sentiment indicators as
noted above. Stay nimble in this volatile market and stay tuned. Good
investing, Mike Burnick
Source: Money and Markets
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