August 14, 2011

• It appears likely that we have seen the selling climax and the start of a bottoming process.

• Further testing of the market lows are to be expected.

• After a waterfall decline in the stock market, as we saw last week, there is almost always a basing period. That period can be divided into 1) a rally, 2) a retest of the lows, and 3) a new uptrend.

Since our August 11th, 2011 posting of the report “What We are Watching”, it has become more likely that we have seen the selling climax and the start of a bottoming process. The Monday, August 9th “waterfall decline” was the first day in which all of the S&P 500 constituents dropped in a single day. Average trading volume over the past five days has reached its highest levels since September 2008. The ratio of declining volume to advancing volume in many indices surged to record levels. The Vix, or fear index, spike to 48, its most extreme level since the market lows of 2009. And the Dow Jones Industrial Average intraday volatility index (the three-day average spread between intraday highs and lows) has jumped to levels usually seen around market bottoms.

The stock market’s action appears to be following the script of the process of bottoming out. But further testing of the market lows are to be expected. Ranging between the recovery highs and the initial lows, the bottoming process can go on for weeks, with volatility, volume, and new lows gradually diminishing on the retests. During this healing process, selling pressure recedes as investors regain confidence, culminating in decisive breadth improvement.

Upside Potential

If the market does indeed continue to advance, the question then becomes how far up will it go this year. Clearly the market has taken out our Risk Level of 1,215-points on the S&P 500 (which, at the time of publication, we noted was very aggressive). If the market remains in a bottoming process, anything more than marginal new lows would be unlikely, with the S&P 500 dropping not much lower than around 1,100-points.

With the bottoming process completed, the S&P 500 could be expected to rally toward resistance in the 1,250-1,275 area, before retesting that low. Unless the outlook includes an imminent recession, a stiff earnings correction, or another round of crisis surrounding European banks, none of which we view as likely events, then equities should be able to make it through that resistance.

Sentiment indicators tell us that the market has a substantial “wall of worry” to climb. And the median price-to-earnings ratio in the S&P 500 would reach its 42-year norm at 1,274-points, suggesting that the market could rally to higher levels before valuations would pose a threat. That’s also supported by the S&P 500’s tendency over the four months following the last two fifteen-percent-plus corrections that ended with the 200-day moving averages still rising. After last year’s correction low, the S&P 500 rallied 20%. After the low in August 1998, the S&P 500 rallied 25% to a new high. Thus after breaking above 1,250, the market could be expected to test the 2011 highs in a revised Reward Zone of 1,350-1,400 points, and advance of 21% to 25% from the August 8th low.

Leadership After a Waterfall Decline

After a waterfall decline in the stock market, as we saw last week, there is almost always a basing period. That period can be divided into 1) a rally, 2) a retest of the lows, and 3) a new uptrend. Leadership has tended to stay defensive through the basing period. In past waterfall declines, small-capitalization stocks have tended to underperform during both the waterfall recovery as well as the retest. After the retest, they have tended to outperform. However, this time we will remain more neutral regarding small-caps, likely preferring large-cap. Why? While a recession is not imminent, we do have economic concerns regarding 2012, so a less risky allocation may be appropriate.

Regarding Growth vs. Value, the performance has been mixed during the basing periods. The consistent message, however, has been that whichever style underperformed during the basing period outperformed once the uptrend resumed, likely reflecting mean reversion tendencies at the beginning of market uptrends.

Dividend-paying stocks have tended to outperform during both the waterfall decline lows to the peak rally phase, and then during the retest phase.

Bottom Line: The stock market has undergone a waterfall decline. The very definition of such a steep drop implies that they come out of nowhere, and this one followed that script. After a waterfall decline in the stock market, as we saw last week, there is almost always a basing period. That period can be divided into 1) a rally, 2) a retest of the lows, and 3) a new uptrend. Thus volatility is not behind us, or the markets. Going back to recent market lows is a high probability as that would be part of the action of the process of bottoming out.