Oversold Again On the Way to "Point B"

By Dr. Duru written for One-Twenty

February 22, 2009

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Here we go again testing another 52-week low in the S&P 500. I hope by now we have all learned to tune out the terms "this is THE bottom", "this is a bottoming process," and, my favorite, "buy now because in 10-20 years you will wish you had done so." The one piece of punditry that intrigued me starting into 2009 was that it seemed even bears expected a big rally to start the year that would then produce a huge opportunity to re-open shorts between March and May. Instead, the big rally of 2009 was squashed right after the first week. I was cautious after the big one-day start to the year. After the "inauguration swoon" I went bearish while acknowledging that we were likely to get more dead-cat bounces before we finally retested the 52-week (and multi-year) lows on the S&P 500. Now that we have essentially retested those lows, I am divided as to whether we break them here or bounce a few more times before the lows break decisively. Time will certainly tell. But we are oversold "enough" for it to make sense to begin positioning for some kind of near-term (sharp?) bounce by reducing shorts and increasing long exposure.

The current market conditions allow some tests of previous analyses. Most importantly, last July, I compared the VIX and T2108, the number of stocks trading above their 40DMA, during oversold conditions and concluded that when T2108 goes below 20% (oversold) and the VIX reaches within 20% of the previous VIX spike, the market has become "close enough" to a short-term bottom. (Note well it could never signal a final climactic bottom). T2108 is now flashing oversold at 13% and first hit oversold conditions on Thursday. Once the VIX hits 65, it will be within 20% of the previous spike. The VIx is currently at 49. It is no surprise then that traders are buying large quantities of calls on the VIX.

The current market conditions are providing an on-going test of my analysis of using T2108 to flag over-bought market conditions. The S&P 500 topped as expected in early January when T2108 reach 70% and then 80% for the first time since the market's peak in October, 2007. The average number of trading days between overbought conditions is 34 and the median is 7 (measured since September 17, 1986). The S&P 500 is now 28 trading days away from January 12 when T2108 last fell out of over-bought conditions. This puts the market at the "69th percentile" for time spent below over-bought conditions. So, in a sense, with T2108 now oversold, we are now well overdue for some kind of bounce. With the right catalysts, this bounce could be long-lasting - measuring in weeks, not days.

While my sentiment has shifted to "less bearish" (for example, I am trying some advice from Nassim Taleb and have dipped into some out-of-the money calls and puts), I am far from bullish. I still have not seen any convincing catalysts for the kind of bounce that can take us out of bear market mode. While many looking for a bottom continue to call unemployment numbers a lagging indicator, I instead choose to cling to it as a leading indicator as long as the numbers fail to improve. Additionally, it seems we are still on the road to what I call "Point B." We are travelling from Point A: the presumed prosperity of the last 25-year bull market. Point B is the point in our market and society where we resolve to accept certain economic realities. The on-going debates and experimentation on the financial system and its banks show that we are still on that road. (I am increasingly agreeing with the folks who argue some form of nationalization for some of our major banks is a foregone conclusion). Point B is also the place where we reach some sort of equilibrium or at least newly established pattern with consumer spending habits. I suspect for many years to come, consumer demand will be much less debt-driven than what we saw in the last bull market. Point B is where we resolve to accept the lower standard of living that will ensue (although I would argue that having a more stable basis for demand is really a higher standard of living when taking into account the long-term health of the nation). Point B is probably even the point when we finally come to terms with our enormous budget deficits.

I also recognize that the stock market has developed a wide gap between winners and losers. While the S&P 500 scrapes at 52-week lows, several technology and commodity names are doing just fine in 2009. The infrastructure and alternative energy themes have largely failed to-date. The pain in financials is of course inescapable. The short-term consideration from this juncture is whether the companies with the poor business models will drag the survivors down, or whether there is enough strength in the good business models to keep us afloat for a while longer.

Be careful out there!

Full disclosure: Long S&P 500 in an index mutual fund. For other disclaimers click here.

DR. DURU®, 2009