A Market Bottom Checklist

The past few trading days have been a nice change of scenery haven’t they?  I haven’t made it a secret that I’m not sold on the idea that we’ve put in an absolute bottom in equities just yet. With that, I’ve been asked a few times what I look for then in a market bottom.

Before going into each point, it’s important to note that predicting or calling a market bottom is not critical to a traders success, far from it. Sticking to your risk management principles and taking trades that fit your strategy are more important than being ‘that guy’ who called the tops and bottoms to the S&P or Nasdaq. The underlying purpose of measuring the health of an uptrend or downtrend (in this case) is to help get an idea of how much risk is built into the market for either direction. I subscribe to the idea that  capital markets are one big rubber band, once that rubber band has been stretched to its maximum resistance it will likely revert to its mean. It’s just a matter of finding the optimal time during that ‘stretching’ to determine if the risk is warranted to begin stepping back into the market.

So with that, below are a few of the things that I look for to gain confidence that a bottom has been put in for equity prices or at least that some of the risk may have diminished from adding equities to the watch list.

1. Momentum divergence. Normally we don’t see equity indices drop and then put in a bottom before creating a lower low. Seeing how momentum reacts after a retracement while testing or setting new lows can be very helpful in determining the phase of a drop in price.  At a market bottom I like to see momentum diverge from price by not continuing its decent to a lower low alongside the index. This tells us that sellers might have run out of powder and an advance or period of consolidation could be in the works.

2. “Risk on” sector confirmation. Just like momentum I like to see ‘risk on’ assets begin to consolidate, taking a breather from their decline. Typically during a drop in equities we see traders shift out of ‘risk on’ sectors like technology and financials and into lower-beta sectors like utilities and health care. At a bottom I try to observe high beta sectors slow their decline in relation to low beta sectors. I’ve found looking at a ratio between the two can be helpful.

3. Bears everywhere you look. Sentiment can be very useful at market troughs. We can look at AAII or Investor Intelligence data to get an idea of investor sentiment towards stocks. We can also apply analysis to COT data to see how traders are positioned, the Volatility Index to determine how much ‘fear’ has been built into prices, and see what varies magazines are putting on their covers. If Us Weekly is discussing the drop in equities rather than Lindsay Lohan being arrested again, there’s a good chance the market’s teeter-totter has become unbalanced towards sellers.

4. Volume confirmation. As mentioned above, markets typically don’t a bottom in a single drop. When/if a lower low is put in we can take a look at total volume to see if it’s rising or falling. If volume is decreasing alongside equity prices then we can assume there are fewer sellers entering the market. However, other factors need to be taken into consideration, for example this week historically experiences lighter than normal trade volume due to the Thanksgiving Holiday.

These four points are far from a Holy Grail to stock trading. These are just a few examples of some of the market relationships I look at when equity prices are in a decline. It’s my opinion we are in the ‘retracement’ phase of a market decline but I’d be happy to be proven wrong. I don’t marry my opinions and am content to shift my view when the market proves me wrong.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+.

Trouble for Equities But With a Chance of Sunshine

Before yesterday’s sell off, which was the first 1% decline in the S&P 500 since late-July, a form of consolidation had been taking place in the major indices while things began to fall apart below the surface.

First up I want to look at the relationship between consumer discretionary and consumer staples. Typically when discretionary stocks outperform staples it’s a sign that traders are comfortable in a ‘risk on’ rally. But when this relationship breaks down and staples begin to outperform, which has they have been the case for over a week now, a warning flag goes u as traders shift into the lower beta names.

We are seeing the same type of breakdown when comparing the relative weekly performance of the Nasdaq Composite to 30-year Treasury bonds. I’ve marked with  dotted red lines each time since 2006 this relationship has fallen below 22, which historically hasn’t lead to happier days for equities prices. However, we did see a whipsaw in 2011 before substantial declines in the S&P took place, so this doesn’t necessary mean we drop like a rock just because of this weakness.

There are still some technical components that give us some hope for a continued advance. First, we have to remember this is how the market initial responded to the QE 2 announcement back in November 2010, a 40 point dip before bulls take back the reins to finish the year on a positive note. Also I’m noticing momentum, based on the McClellan Osc. appears to have entered oversold territory on a very short-term basis based on certain metrics.

So while it seems traders are taking risk off the table with the outperformance in the lower-beta consumer staples space and 30-year Treasury’s, the current price action in equities doesn’t seem to be out of the ordinary when it comes to QE announcements. It still seems that 1430 is the level to watch on the downside, if we get to that point.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+.

A Sign of Relief and A Sign of Weakness

Things appear to have broken down pretty quick over the last few trading sessions. What took 6 days to build only took 3 to destroy in the S&P 500. Apple came out with weaker-than-expected numbers after the close today, as did Netflix. It doesn’t feel like we have experienced enough pain for a bottom. Although there is one chart that sticks out to me that indicates we might see some type of relief or consolidation.

Below is the percent of Nasdaq issues hitting record highs. I’ve put green dotted lines to show when the figure has broken past 10% and then come back up. As you can see this has typically happened at or near at least short-term bottoms. The most recent market action has taken us to touch the 10% threshold and back up, so it’s not as clean-cut as previous instances. Now a chart like this should be filed under ‘chart porn’, and not traded upon by itself but it’s success rate since 2010 is pretty interesting.

What is keeping me considered about equities and not fully convinced everything negative has been baked into this market is the fact small caps have been getting destroyed. We last looked at this chart of IWM back on July 19th, due to the negative divergence with large caps, right before this recent drop. As you can see, over the past two days, small caps have sold off a lot harder than large caps as traders are likely shedding their higher beta positions. We are seeing the same type action in 10-year Treasuries, with yields dropping to new all-time lows, closing out today at 1.40%.

Tomorrow Tim Geithner will testify before the House Financial Services Committee about the U.S. recovery, Europe, and the fiscal cliff, which could give traders some reasons to kick up volatility a notch. The market will also be looking to digest earnings data tomorrow from Boeing, Delta, Lilly, Pepsi, and Whole Foods. Be smart out there.

 
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+.