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As investors, in 2009 many of us were aware that the markets were unjustifiably low, yet many (myself included) were hesitant to put money behind that belief due to the noise in the markets. It is difficult to act on an emotional buy when the environment is catered to accepting fear, and a clear mind supported by metrics can help navigate such an environment. I am presenting a strategy that attempts to navigate the noise that surrounds market lows and quantify a point where sentiment has soured beyond what is warranted.

If you have read any of my articles before, you'll likely recall that I intermittently substitute ratios such as P/E or P/B as a proxy for investor sentiment. I believe that each ratio provides some insight into sentiment, which is sometimes viewed as non-quantifiable. But, is something so cerebral as sentiment toward an index (the market, essentially) quantifiable and can this be used as a determination for an entry point? My answer to those questions is yes.

Ratio Trends During Crises

The lows we've seen during the early 2000s, 2009, and during the treasury downgrade in 2011 were all characterized by ratios that deviated significantly downward from their recent trends. This was due to the overwhelming fear that was in the markets during those times. EPS and book values remained unchanged during month-to-month periods, yet sentiment drove index levels far below what the supporting fundamentals would suggest is rational.

The chart below for the S&P 500 demonstrates buy signals for the strategy that I have developed to determine when markets are in extremely oversold territory. As the chart shows, my strategy signaled buy opportunities at or near lows during the various crises in the past decade. The strategy attempts to quantify when sentiment has soured and index ratios were discounted far below their recent trends. It is normal for EPS and P/E ratios (or P/B and book values) to decline in times of uncertainty, yet it is not normal for sentiment to become so irrational that investors are only willing to pay much less for the same amount of EPS or book value as they would have previously. This discounting of each ratio from its trend (adverse market sentiment, essentially) creates a buy opportunity with a high level of conviction, although rare.

Click to enlarge image.

The S&P 500 chart shows that my strategy has achieved success in the following months when attempting to determine market lows in extremely adverse scenarios. This is why I believe future scenarios where such a discount is present will make for a probable profit opportunity.

My Strategy -- Well, the Basics of It at Least

As I mentioned previously, sentiment souring beyond recent trends is quantifiable through viewing ratios in the context of a discount to their recent trends. I have used a strategy of measuring index ratios over the long term to determine the trend using a monthly simple or exponential moving average. The time frame you choose is up to you, yet I favor the longer term as my intent is to determine extremely adverse scenarios. A shorter-term trend does provide insight, yet more noise in those signals -- thus, more false signals.

For the second part, I then reviewed what the specific discount to the trend was for each ratio during the last 15 years when markets were at their lows. This provided me with the specific discounts exhibited during each time frame. That's pretty much it actually. There are some intricacies I have added to optimize the strategy but you can see it is a ratio trend following strategy. You can find index ratios easily for the S&P 500 by going to Standard & Poor's website. Others such as the Dow, or even international indexes, may require a paid service such as Bloomberg.

S&P 500 Buy Opportunity

Based on historical discounts to P/E, I am suggesting a long entry for the SPDR S&P 500 (NYSEARCA:SPY) at $107, which is applicable for the remainder of the quarter. This entry point is only relevant for the next months as you'll recall that my method utilizes a discount to the recent trend for P/E. As the trend changes, the buy level dynamically does so as well.

I know some of you may be thinking that this price level is far below anything that will likely be achieved in the coming months. I'd agree with you. If there is a hard landing in China combined with Draghi not living up to his promise to maintain the euro, then we could possibly see the S&P 500 trend down sharply, although that's unlikely. I present this number to you for the sole purpose of evidencing how far the S&P 500 must retreat for the markets to be in a similar mindset as what we saw in 2002, 2009, and 2011. These events are rare, yet the conviction behind a buy during similar future scenarios is high and it can't hurt to be prepared for the worst case scenario.

This strategy is also applicable for determining strike prices when selling puts or credit put spreads. I believe we are in a favorable environment for long investors in the coming months, so I am comfortable selling OOTM puts above my $107 adverse scenario target. I am still risk adverse when it comes to options, so I would suggest selling the $120 September/October puts or a put spread to reduce the margin requirements. I am comfortable with this time frame as you are getting some compensation for the risk and my strategy suggests the $120 strike would only be reached in a strong bear market. The strike is approximately a 15% discount to current prices and I don't foresee sentiment souring that aggressively by September/October. If it does, I am OK with loading up with some SPY shares and then selling more puts at my $107 entry point.

Other Index Entry Points

I've utilized this strategy across more than just the S&P 500 and it is important to do so as the signals are rare. The more indexes studied at once, the better. Otherwise, I am sure you'll be waiting years in between buy signals. My analysis suggests the following entry points for some major indexes:

  • SPDR DJIA (NYSEARCA:DIA) -- $109.70
  • Buy target discount -- 16.6%
  • Hang Seng Index -- 18,285
  • Buy target discount -- 8.9%
  • Euro Stoxx 50 -- 2,074
  • Buy target discount -- 10.7%

It is worth noting that I am utilizing P/B for the Hang Seng and Euro Stoxx 50 as it is a more reliable metric than using P/E due to its high volatility and negative EPS, which negates the strategies effectiveness. The Hang Seng has the most potential to reach my buy target since the slowdown in China has driven the index down significantly in the last three quarters and requires the smallest percentage decline to reach an adverse, oversold territory.

Source: SPY: Gauging Sentiment To Trade Indexes