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Is It A Bottom Yet\?

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Is It A Bottom Yet?

Parents of small children will recognize the slight variation of the popular question "Are we there yet?" If you listen to CNBC, this seems to be the most popular question asked of anyone who can fog a mirror. When will we know it's a bottom? I'm as eager as the next guy (or gal) to know the answer to that question, but I'm not so na´ve as to believe that anyone (regardless of past track record) can tell me where the bottom lies. That question is only answerable in hindsight, but there are some important clues that we can observe to determine when we are likely getting close to that elusive bottom. Keep in mind that I'm not talking about THE BOTTOM here. Rather, I am referring to the next tradable bottom that leads to the next bear market rally.

Each of us have different broad market indicators that we monitor to give us a feel for the health of the overall market and the likelihood that this bounce has the potential to turn into a rally. Of course, the starting point for assessing solid reaction points begins with monitoring price action, with an eye towards support/resistance levels and the price action relative to important moving averages, Fibonacci retracement levels and Bollinger bands/Envelopes.

Some traders then focus on the Put/Call ratio and the TRIN for picking market bottoms, while others tend to watch the Advance/Decline ratio and the ratio of New Highs vs. New Lows. All of these are valid and important measures for attempting to assess the odds of the markets stopping their slide and staging a significant rally. The one additional part of the puzzle that I think deserves consideration is the volatility measures that best quantify fear in the marketplace.

We're talking about the VIX (for the S&P 100 or OEX) and the VXN (for the NASDAQ-100). As markets decline, the VIX and VXN rise due to the increasing fear by market participants unsure of where the decline will end. These volatility indicators do not measure the ratio of puts and calls, but instead measure the implied volatility of options on the particular index to which it is related. Due to questions in the past, I went into great detail on how the VIX is calculated in an article late last year. For those of you that missed it and have an interest in the underlying formulation, here is the link.

VIX Details for the Masochist

While we can't necessarily use the action of the VIX to predict a market bottom (due to the fact that it is actually a lagging or at best, coincident indicator), we can use its action relative to its historical range to assess fear in the market and thus the likelihood of a sustained market rebound. Simply put, when the VIX makes a run to (or above) the upper end of its historical range AND THEN REVERSES, it usually presages a significant market bottom.

New readers may be wondering why we want to see a high level of fear before feeling the markets are ready to rally. The reason is that the bulls need a wall of worry to scale to sustain a rally. Worried investors will stay on the sidelines as the rally gets started. Then, as the rally makes upward progress, these investors come off the sidelines, providing the buying necessary to push the market a little higher, which in turn provides the motivation for more buyers to appear. This is precisely the reason why it is functionally impractical for a meaningful rally to begin when the VIX is trading near the lower end of its historical range. When the VIX is low, it reflects investor complacency, or put another way, the expectation that the markets will rise. If the bulk of investors believe that the markets will rise, then it goes without saying that they are probably already invested. The problem that creates is that there is not the bulk of cash on the sidelines to propel the markets higher.

In the past, I've looked at the historical pattern of the VIX relative to the OEX, and I think I've made a strong case that the VIX deserves our attention near expected market bottoms. For any of you that are still unconvinced, I offer the chart below, which shows the action of the OEX as it relates to the VIX over the past year.

Weekly Charts of S&P 100 (OEX) vs. VIX

Now let's look at the same set of charts on a daily timeframe so that we can see how the current action is shaping up.

Daily Charts of S&P 100 (OEX) vs. VIX

Judging from the way the VIX has moved up to the top of its historical range twice in the past week as the OEX has come down to test major support, not far above the September lows, I think the rebound that began this afternoon has a fighting chance of sticking. As I mentioned above the VIX is not very useful in a predictive manner, but when this sentiment indicator is signifying a heightened level of uncertainty, while at the same time the markets are testing major lows, we know to start at least start contemplating the possibility of a trading bottom being put in over the near term. While I would prefer to see a VIX in the 40-60 range like we saw last September, I don't think we are going to get a big, flashing neon sign like that this time around.

I haven't gone into any detail on any of the other indicators mentioned at the top of this article, but many of them have been pointing to the likelihood that we could find a tradable bottom soon. Given that the OEX is trading near its September lows, and really seems determined to hold the $500 support level, for the first time in weeks, I am considering trading this market from the long side for more than a day-trade.

But here is the one thing that causes me concern. Looking at the intraday pattern of the VIX it has been most eager to fall back from the 30 level over the past week. In other words, the fear disappears exceedingly quickly. In my opinion, that is not the sort of thing that will make for a long-lived bottom. Note that the intraday high on the VIX last Friday was 29.94, but the closing value was significantly lower at 26.65. We saw a similar pattern today, with an intraday high of 29.34 before the VIX collapsed back down to 26.98. Both of those days saw the OEX stage late-day rebounds off the lows to end near their highs of the days. That is positive. But the pullback in the VIX on both occasions was larger than should be expected for such a modest recovery in price.

What I'll personally be looking for in the days ahead is a retest of the $500 level on the OEX accompanied by another VIX move up near the 30 level that does not collapse on the slightest hint of a rebound. Should that occur, I will consider it a solid entry for the hoped-for summer rally. My intent here is not to provide you with a trade recommendation; the guys in the Market Monitor do a better job of that than I can. But hopefully my musings here today give you another perspective on what to look for as we pursue that elusive market bottom.

Have a great week!

Mark

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