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More on "Capitulation, Panics and Turnarounds"

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I was not able to write this column in my 'usual' Thursday time slot last week and given all that's happened in recent days and especially today, I thought to add some analysis and charts relating to the subject of whether today's sell off might be a low for a while if not a 'final' low. When I last wrote on the subject of 'capitulation' bottoms back earlier this month (9/18), I thought that perhaps we were seeing this type bottom when the Dow closed the day at 10459 and here we are today at 10365.

The dictionary definition of "capitulation" relates to the act of surrendering or giving up. Charles Dow said eons ago that the market in his long experience NEVER made a major bottom without this quality of 'giving up' on stocks among the majority of investors. A major question is how you measure 'capitulation' and there are no perfect tools to do this. The one that has come closest for me over the years is really a measure of (option) trader sentiment or how much volume is seen in equities calls versus puts.

Ahead of intermediate to major bottoms, we see at least 1-day if not a few where daily put volume is greater than that of equities call volume, so the ratio of calls to puts is less than 1 when dividing total call volume by put volume. I do it this way so that it's like other 'overbought/oversold' indicators where the lower the number, the higher is the degree of bearishness. The higher the number, the greater is the degree of bullishness (e.g., a reading of 2 or above where call volume runs double that of put volume).

We have an historical pattern relating to my call/put indicator in a big 'capitulation' bottom in 2002, at the end of the bear market following the dot-com bust, where traders and investors gave up on stocks and assumed that the decline was going to never end so to speak. The bulls surrender!

I'm not saying that this current economic and market situation is going to be the SAME as the 2002 bottom, as the very shaky economic conditions this time may well be worse than 2002. Because of this widely perceived perception I would anticipate that my 'sentiment' indicator would measure significantly higher levels of bearishness if today's low was at least a tradable bottom; e.g., time to cover puts and buy some calls. Not so, as you'll see.

First, a look at the 2002 bottom in terms of the CBOE equities call to put volume ratio or what I call my sentiment 'indicator'. I display this indicator with the S&P 100 (OEX) chart, but this indicator 'stands in' very well for the OVERALL market sentiment; i.e., the collective expectation as to further declines or the reverse.


A few things I've learned about this type sentiment indicator:
-Daily sentiment extremes tend to come BEFORE an actual bottom
-At a MAJOR bottom there tends to be a cluster of such extreme readings
-It's not crucial to use a moving average to smooth the extremes but a 5-day average can be illuminative

Call/Put readings of 1.1 and below (below the green line above) suggest an 'oversold' market in the sense that the bearish outlook has gotten so extreme that the market gets into a position of being able to recover once the selling has dried up from the large number of investors panicked into dumping stock. This is also reflected in the preponderance of put volume relative to calls. Selling puts reflects a bullish or an outlook for a sideways trend of course, but experience suggests that a lot of the activity at bottoms in puts are hedges for individual stock holdings or speculative buys in the expectation of another downswing.

Note in the above chart that in 2002 the final bottom, besides being a double bottom low which is a powerful bullish pattern, but a cluster of 'bullish' call/put readings came (with one exception) before the 2002 bottom. Moreover the 5-day average got 'fully' oversold ahead of the final bottom, which is an uncommon occurrence. I take approaches to a prior major low as potentially bullish given the prospect for a double bottom, but when the market outlook is so heavily bearish, investors tend to anticipate a breakdown to a substantially lower low.


When we look at the recent pattern for my trader sentiment indicator seen above, it's notable for:

1.) How the 5-day CPRATIO average dipped to an 'oversold' extreme a few days back, suggesting today's lows in the major indexes might be it for a while. Today's decline looks extreme enough. What's lacking is the typical cluster of individual daily readings at and below 1.1 to suggest any kind of 'final' bottom. There were two tradable bottoms reflected by the same type 5-day CPRATIO extreme back in late-January and mid-March that correlated pretty closely to short to intermediate-term lows, especially around the March extreme.

2.) How FAST sentiment got to a bullish ('overbought') extreme on the recent rebound in OEX to 583 and how the CPRATIO didn't fall to the kind of extreme TODAY that would be suggested by the magnitude of today's decline. Too many traders anticipating a bottom? Probably. I'm not sure if we've at or near at least a temporary or interim bottom, but do know that MAJOR bottoms tend to occur only after there are a few (2-3 or more) bearish extremes in my indicator caused by a certain high level of high daily put volume relative to calls.

Another technical characteristic of major bottoms tends to be if and when prices reach major prior lows and/or register an oversold extreme in terms of the Relative Strength Index (RSI) indicator applied to daily and weekly charts. Due to the nature of the unfolding of this particular decline, the daily RSI readings haven't yet reached extremes, especially in the S&P and Dow. However, the weekly RSI levels are getting to very oversold levels. I will close with the Nasdaq (Composite) and S&P 500 weekly charts. However, not all prior lows that might suggest technical support/buying interest have also been reached, such as 10,000 on the Dow as highlighted on the INDU weekly chart below.

You'll note with the Dow 8-week RSI seen above that this widely followed index is now as oversold as it was back at the 2005 bottom, but we haven't seen 10000 retested again which has got to be a major psychological support.

In the case of the Nasdaq Composite (COMP), this index is more oversold than the Dow Jones Average as the RSI seen below is measured on a longer-term 13-week basis and suggests that COMP is already more oversold than it was at the 2005 and 2006 lows. Can we make major trading decisions based on such indicators? I would say no as to hitting any particular oversold extremes, as any overbought or oversold market can just get more extreme. But, when such extremes occur along with successful retests of prior major lows, such as COMP 1900 and Dow 10000, yes.


Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

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