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There is nothing quite as fun and exciting as picking a bottom in a given stock or the stock market as a whole. Well, at least up until the point where the chosen instrument ends its brief bounce off of a short-term low and plunges back down below the most recent support level and quickly moves to new low ground well below your entry point leaving you feeling like Leonardo Decaprio and/or Kate Winslet clinging to the stern of the Titanic during the final plunge (because, I mean, why bother with a stop-loss order when it’s the bottom, for crying out loud?). Those of you who rode this ship (and I think you know who you are) know what I’m talking about. Still, there is something exciting about picking a bottom, is there not? Sooooooo, hey, how about that stock market!?

My guess is that a fair number of people are looking at the stock market these days and wondering if maybe, just maybe, the market is bottoming out. Which is due in part to the fact that there is more than just a fair amount of people who are starting to believe that Armageddon is at hand.

There are several factors to contemplate:

1) First off, the major market averages have all formed your classic “double bottom” formation – at least for the moment. See Charts 1, 2 and 3.

Chart 1 – Nasdaq 100 (NDX)

Chart 2 – Russell 2000 Small-Cap Index (RUT)

Chart 3 – S&P 500 Index (SPX)

As you can see, all three of the major averages displayed in Charts 1, 2 and 3 formed a “classic” double bottom, and did so with “classic” confirmations from several key indicators. So does this guarantee that the worst is over and that a big rally lies just ahead? If only it were that easy. At the moment the bigger question is if these recent lows will hold until the end of the week. Still, there are other factors also suggesting that a bottom may have been formed or is in the process of forming. A subsequent plunge back down to or even through the recent lows – if reversed back above the support levels drawn in Charts 1, 2 and 3 would only seem to bolster the possibility.

2) The economic news is all uniformly bad: the housing slump continues, the credit crunch tightens further, a recession seems more and more obvious, gas prices keep rising, the Fed appears poised to cut interest rates to –3.5% if necessary, the dollar continues to plunge – and oh, a major brokerage firm went “poof." This confluence of factors is enough to send the average individual into a panic and a contrarian into a fit of unbridled joy. The fear of course remains that there is still way more bad news yet to come.

3) Bearish sentiment is rising sharply. The latest CBOE put/call ratio recently exceeded 1.25, a very oversold reading. In Chart 4 you can see that the VXO Index – which uses implied option volatility to measure fear or complacency in the market - recently spiked to a level that has brought a least a short-term bottom on several previous occasions.

Chart 4 – VXO Spikes, SPY follows with a bounce (what about this time?)

4) Speaking of bearish sentiment, the latest AAII sentiment poll found 59% of all respondents to be “bearish” and only 20% “bullish." Thus, the ratio of bulls to bulls plus bears is just 25.7%. Among the 1077 weekly readings accumulated since 1987, this is the 15^th lowest (i.e., theoretically bullish as a contrary indicator) reading.

Chart 5 displays the 10-week moving average of:

AAII Bulls / (AAII Bulls plus AAII Bears)

As you can see, the present reading of this measure is at its lowest level since the bottom of late 1990 was forming. This does not necessarily mean that today is a great day to buy; it simply means that it might be time to start considering the possibility that we are closer to the next bottom than we are from the last top.

Chart 5 – 10-week average of AAII Bulls / (AAII Bulls + Bears)

5) Lastly, looking at the stock market on a long-term seasonal basis, we just entered into a seasonally favorable period. Table 1 displays the performance of the Dow between the end of February of Year “8” of the decade (1908, 1918, 1928, etc.) through September of Year “9” of each decade, since 1908.

Table 1 – Historically Favorable Seasonal Timeframe

As you can see, in decades past this period has shown a strong tendency to be one of the most bullish periods for the stock market.

Summary

So is the bottom in? Am I urging everyone to rush out and “bet the ranch” in the stock market? Not exactly. I do wish to point out, however, that historically the market bottoms out when things look their worst. Anybody taken a look around lately? A lot of bad news has already been factored into stock prices. The S&P 500, the Nasdaq 100 and the Russell 2000, have experienced peak-to-trough declines of –20%, -25% and –25%. My job with this column is not to give investment advice but to educate. In light of all that we have “learned” from the items listed in this week’s piece, aggressive “types” might consider putting some money to work with stops below the recent lows. Less aggressive types might start girding themselves to put some money into the market and start monitoring some trend-confirming indicators as a trigger to get in.

Remember that ultimately the goal is not to “pick the bottom," but rather to maximize profitability and minimize risk. Putting some money to work in a deeply oversold market – provided you utilize adequate risk control measures – can be part of such a plan, as long as you recognize what you are getting yourself into. Recognizing a potentially “washed out” market and resolving to make your move as soon as there is an objective indication that the tide has turned can also be part of achieving that objective.

In the meantime, it never hurts to remember where the nearest lifeboat is.

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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