September 14, 2007

The recent stock market correction hit a low on August 15th.  And usually I wouldn’t waste any time writing about a stock market correction because they happen all the time – they’re just too routine to mention.  But this last one, which brought the market down ten-percent, was the first ten-percent correction in about four-and-a-half years (the 2nd longest stretch without a 10% correction in market history).  Typically we experience a ten-percent correction every fourteen months – it’s pretty normal.  But because I think a lot of us may forget about the regularity of such market price action and thus get a little more nervous than we normally should, I thought it would be appropriate to comment on the month-long aftermath of the August 15th bottom.

While the month-long rally has been impressive on the surface, its internal strength has not been so impressive as to guarantee that it is sustainable.  There is still the very real and very likely risk of retesting the August lows of about 1,375 points on the S&P 500.  However, while not significantly impressive, the internal strength has been strong enough to argue that 1) a 20% crash is unlikely and 2) even if there were a 20% crash that it would be short-lived (think 1998).  As a result, there is no real need to sell into rallies.

As most of you should know by now, when I talk about “this could happen or that could happen”, I am not trying to take both sides of a possibility, rather I am attempting to explain the probabilities of possibilities (i.e. what is most likely to happen).  Whenever the market comes off of a major high, like it did in mid-July, it is usually not possible to assign with certainty (or at least a high degree of probability) an opinion on whether the market’s slide started a new bear market or whether it is just walking through a short-term correction within a continuing cyclical bull market.  However, the level of certainty typically improves after we see a rally off of intermediate lows –a rally like what we have seen over the last month.

The fact that the level of certainty typically improves after we see a rally off of intermediate lows is the good news.  The bad news is the emphasis on the word “typically.”  If in the last month the rally was strong in terms of both breadth and volume, that would indicate renewed buying enthusiasm and that would signal a high probability of a sustained rally with higher market prices.

However, if the breadth is weak (if the rally has leadership limited to just a few sectors or asset classes) and buying enthusiasm is tentative (as measured by low trading volume) then that would typically signal a high probability of a renewed correction.

As far as breadth goes, it hasn’t been bad.  Sure, it could have been better, but it has been strong enough to give bulls the benefit of the doubt.  However, the volume has been light.  The rise in stock prices has come largely from decreased supply – said another way, there have not been a lot of sellers.  On the surface, that sounds like a good thing.  And while it is not terrible, it is not as bullish as when selling is at typical levels and buying has dramatically picked up (it shows real buying enthusiasm).  Instead we have seen buying pick up somewhat, but selling has dried up (think about the forces of supply vs. demand – prices are being driven up because of shrinking supply, not growing demand).

Weighing the two – breadth and volume – I have seen no clear evidence to suggest that the month-long rally is anything more than just a bounce back from the August 16th lows.  To be clear, sustainable rallies off of market lows often times start with low buying volume combined with an absence of sales.  But over weeks we will usually see that buying volume dramatically picks up as both prices and investor confidence rebuild.  But demand has yet to pick up convincingly.  Depending on Fed language next Tuesday perhaps we will see renewed demand and more evidence to suggest that this rally is something more than just a brief bounce.  But until we see further improvement of internals there is still the looming possibility of the S&P 500 dipping back to about 1,375 points.

All of this breadth and volume talk would be moot if, in fact, I could point to August 15th and say it was a major bottom.  Below is a chart Ned Davis Research put together for us and it measures a dozen indicators used to help identify the extremes you might find around bear market bottoms.  At major market bottoms we tend to see high values for volume, volatility, and the risk premium; we tend to see low values for breadth and sentiment at market bottoms.

By comparing the latest measurements to those reached at other bottoms over the past quarter-century and ranking then compared to the past numbers we can get a sense of whether or not we can pinpoint August 15th as a meaningful bottom.

When you look at the rankings you see that declining/advancing volume and total volume both ranked 2nd out of 8 in terms of intensity.  These two indicators suggest that the market has bottomed.

When you look at the other rankings you see that they lack any decisiveness compared to extremes at past bottoms.  Thus ten of the twelve indicators suggest that the market did not hit a bottom last month.

When you look at these dozen indicators in the aggregate it is clear to see that in August we did not witness a level of capitulation typically experienced at major bottoms.  However, while there is not enough evidence to suggest that there has been a major bottom, there is enough evidence to argue that we have drawn a line in the sand (a line that we may very well step up to before we get out of October) at an intermediate correction low at or about 1,375 points on the S&P 500. 

Still, that leaves us with the task of trying to figure out which direction the next ten percentage points of market movement will go – 10% up, or 10% down?  And while I try to make it my job to figure out the answer to that question, it is perhaps timely for me to steal a line that Peter Lynch, the famed ex-manager of the Fidelity Magellan fund – I don’t know in which direction the next 1,000 points will go for the Dow, but the next 10,000 will be up