Searching for a Market Bottom

As of the close on Friday, the Russell 2000 Value was down 9.1% year-to-date, and 14.8% of its high set in less than two months ago, making it the worst market capitalization and style loser for the year. The worst performing sector, the Small Cap Financials, is off over 22% year-to-date.

What started out as housing jitters has mushroomed into a credit market revaluation the likes of which has not been seen since 1998. Valuations on some CDO’s are as low as 30 cents on the dollar, if there is a bid to be found. Major Wall Street prime brokers are struggling to determine valuations and risk associated with the leveraged hedged funds they custody. The net take away is the credit revaluation will likely claim more hedge fund victims before all is said and done.

The corporate credit market has come to a screeching halt. The Wall Street Journal reported that July was the slowest corporate bond credit issuance month since 1990. The backlog is over 300 billion dollars, including many of private equity financing deals resulting from the takeovers earlier this year. Although the S&P500’s 15X PE seems relatively cheap given recent historical levels, investors are bracing themselves for downward earnings revisions that threaten to revalue multiples. The picture looks bleak.

Frequent readers will recall me saying that recent Fed rate cut activity has been centered around financial crises. The good news seems to be at least we are finally facing a crisis for the Fed to react to. The bad news is the Fed rarely acts preemptively to ward off a crisis, so things will probably have to get a little worse before they get better. The Fed has been on hold now 14 months. Only one time in the last ten years has the Fed been on hold longer before cutting, and that was October of 1998. To be sure, there are still inflation worries, especially with oil trading at a near a 52 week high, smack in the middle of hurricane season. A hurricane could act at the great spoiler, spiking energy prices and stoking inflation fears.

It’s never wise to rely on one indicator to determine market tops and bottoms, but there is one that has been fairly reliable, the VIX. Low levels tend to be described as complacency, and high levels are called fear. The VIX closed Friday at 25.16, the highest level since March of 2003. Although a high reading alone can be looked at as a signal, I prefer to look at the relative change. Statistically speaking, a three sigma move (three times the standard deviation) happens 0.27% of the time. In the last 10 years the VIX has had nine - three sigma moves to the upside, each of which marked a short-term market bottom. The length of the three sigma move is also of interest. Four of the nine – three sigma moves, including our current move, have been longer than three months, in each case the market rally the ensued broke new 52 week highs. The even more interesting to note is that the probability of a Fed easing increased with the length of the three sigma move.

The bottom line is, there will be a market bottom. Stocks don’t drop indefinitely because the valuation for the whole market doesn’t belong at zero. When the market sells off every day investors all head for the door at the same time, this is called capitulation and the VIX is an excellent barometer to capture this emotion. I don’t know exactly when the Fed will step up, or the market will bottom, but if the VIX is any indicator, and it has been in the past, we are likely getting close. I wouldn’t be at all surprised to see the Fed try and calm the markets this week by reassuring investors that should accommodative policy be called for to stave off financial crisis the Fed will react.