Stocks turned in their best performance in more than a month last week, leading many observers to believe at least an intermediate-term bottom is being formed, messily and noisily.
By intermediate, they mean that it may last at least a few weeks to a few months before the bottom drops out again in 2009. And by messy they mean the volatility.
I’m not so sure. I would like to think that an important low is forming, and can see evidence to support it. But if you step aside from the daily noise, and stick to our discipline of waiting for a sustained improvement in stock demand, it’s hard to see enough improvement to get excited about.
At the risk of sounding wish-washy, the bottom line is that we may be astride a real bottoming process, or we may be entering a period of the greatest danger yet. I recommend that you hope for the former and prepare for the latter.
The difference in these views emerges not just in their outlook, but in the speed at which events might unfold. For if the market is truly bottoming, then the process will likely be slow and will provide us with relatively low-risk entry points once upside resistance barriers are cleared. So there would be no rush to act until conditions materially improve.But if the danger scenario is more accurate, a trap door will open, and it will be impossible to jump out of the way quickly enough.
Short of a rocket ride back to last year’s highs, the best-case scenario emerging now would be a long-lasting range-trade from here with a bottom around S&P 850 and a top at S&P 1,200 punctuated with a ton of volatility in between, offering lots of opportunity for swing-traders and frustration for buy-and-holders.
My greatest concern comes from the…
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…volatility. We all know by now that when the CBOE Volatility Index ($VIX) rises, it signals an increase in fear due to the way it measures option premium demand. In normal times of the past 10 years, a spike above 35 has signaled enough panic to point to the potential for a capitulation bottom. Yet one little known fact about the VIX is that it only signals a bottom when it falls in a meaningful way; as it rises, it just signals more fear to come.
And unfortunately the latter is what we’re seeing now: The VIX is at a record weekly closing high of 70.3 after briefly scorching 81 on Thursday. You might say that volatility is one of the few bull markets in the world right now, along with the U.S. dollar. And that is not a good thing.
How volatile has it been lately? Well, the average daily range for the Dow Jones Industrials Average this month has been 674 points, according to analyst Tom McClellan. Imagine that: The Dow on Friday traded down 200 points, then up 300 points, then closed down 4% from the high—and its 563-point range was below average! Moreover last week included the second largest daily point loss for the Dow in history—as well as the largest daily point gain in history.
Forced Selling vs. Opportunism
There has not been much surprising economic news lately to produce this kind of vacillation, so it’s not really about fundamentals. Therefore the volatility has really just come from the merging streams of bulls and bear, a sort of eddying effect that does often tend to happen amid long-term, multiyear bottoming formations as so-called weak hands dump stocks to strong hands.
I know that everyone would prefer that a bottom be an event, but in recent years it has tended to be a process. In 1987, 1998 and 2002, bottoms were very up-and-down affairs as fear met greed in a dark alley and duked it out. In all three cases, intense declines to multiyear lows were tested more than once, with the first two retests occurring six weeks later and the second one six months later.
We’ve already had one test of the major market indexes’ recent lows on Friday, but if the market feels it needs another one in six weeks that would be the week before Thanksgiving. Expect the bumpy ride to persist. Tomorrow, I’ll tell you about an alternative, and much more sinister, scenario. In the meantime, check out Trader’s Advantage to learn how to trade this tape.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.
