Fear Still Dominates, But Probabilities Point to An Impending, Positive Rally

Having just come off the worst week in the stock market's history, panic is in the air.  For last week, the Dow Jones Industrial Average [Dow] fell nearly 2,000 points and experienced a loss of 18.4%.  The Dow has now been negative for 8 consecutive days and has closed lower 9 of the last 10 trading days. 

On September 26^th, the Dow closed at 11,143.  Since then we have seen Congress block and then pass a rescue bill, the ban on short selling extended and expired, coordinated interest rate reduction by central banks across the globe, and countless policy movements by many countries with the hope of stopping global panic and returning normalcy to the financial markets. 

Throughout these two weeks, fear has dominated, every asset class has been sold and the Dow has crashed 24%.  This drop has extended the current bear market to a loss of 40% from the peak reached a year ago.

These losses are staggering.  However, more disappointing is that the market seems unable to rally, even for a day, from extremely oversold conditions.  For perspective, consider the 1987 stock market crash.  Through September 30, 1987, the Dow was higher for the year by 37%.  The Dow continued higher for the first week of October, began to head lower and crashed 22.6% on October 19, 1987.  After the crash, the Dow was down 33% for the month of October, but proceeded to rally 14.6% over the next nine trading days with positive closes on 6 of those 9 days. 

Compared to the current environment, we have experienced similar losses, but they have occurred in an unrelenting fashion.  As the market heads lower each day, investor enthusiasm is sapped as we question why an oversold market cannot rally and wonder when the end of the decline will occur.  The inability to rally for even one day leaves investors fearful that markets may never return to normal.

I often write about the need to examine investor sentiment, position against the crowd and reap profits when markets stabilize.  Looking at four different measures, I see unprecedented levels of fear. 

Using my timing model, only one stock is rated a buy, resulting in 99% of stocks being rated as sells.  This is unlike any reading I have ever witnessed and speaks to the extremely oversold nature of this market. 

VIX currently trades near 70 and is 60% higher than the prior peak during the Long Term Capital meltdown.  The NYSE bullish percentage stands at 2.7%.  This compares with nearly 25% during the dot-com bear market and 8% following the 1987 crash. 

Similarly, the percentage of stocks trading above their 50 day moving average has dropped to 1.3% - well below the levels seen at prior market bottoms.  Consolidating these data points, the clear view is that we are experiencing a fear-driven crash that has created the most oversold market of the past 25 years. 

The key to successful investing is looking at probabilities, making your best judgment and employing capital when the likelihood favors success.  Applying probabilities to this market, it is likely that we are approaching a large, positive rally.  As always, the question remains, when? 

Many investors believe oversold markets need to immediately reverse conditions.  However, oversold markets can remain oversold.  I bought stocks last Tuesday and Wednesday and have nothing to show but losses.  While the CNBC crowd finds a need to call a bottom, I will resist.  There is no clear answer to when this market decline will end, what the next price move will be or which stock sectors will outperform others.  Instead, focus upon the market participants, broad market technicals and individual stock fundamentals.

Assessing these three areas, the only people who have prospered over the past few weeks have been the bears.  At this point, with large gains, logic would dictate they reduce position sizes to avoid giving back hard fought profits.  This will create a mild amount of buying interest while also reducing selling pressure.  I have covered the technicals above. 

The logical outcome would be for the market to either stabilize or reverse the oversold condition and head higher.  Finally, from a fundamentals viewpoint, stocks are trading at levels we have not seen in years.  As examples, Chubb (CB) trades at a 6 P/E and 3.30% dividend yield.  Pfizer (PFE) has an 11 P/E and 8.5% dividend yield.  These are levels not seen in years and offer excellent value for a patient, long term investor.

Adding the factors together, we see solid value, an oversold market and eventual end to selling pressure.  This increases the probability that the next move will be higher.  Implementing this view is more difficult.  We must remember that this decline will eventually run its course and markets will improve. 

To those unwilling to deploy capital, I understand.  For those thinking of selling now or going short to try to capture more downside, be cautious.  Markets have a way of reversing once too many people have crowded into the same trade.  Continuing to sell is crowding into a trade that will eventually reverse course and yield large losses.

Comments

[BlueOkie:]

How can you beat a 8.5% yield in today's credit market.

2008 Oct 13 08:22 AM

[InvestorDas...:]

The period from 1999 to 2036 is shaping up to be a lot like 1962 to 1983 - essentially flat if you buy-n-hold, but with several down 50% then up 100% runs with each leg lasting multiple years, and ending the longer period at 0% capital gain. As bookends to the flat time, 1983 to 1999 was a very nice bull run and so was 1943 to 1962.

Mr. Hannon is perfectly right, in our opinion. The current market may test the 2002 low, which could happen in only a day or two given 1000+ point DJIA trading range per day. But investing now, assuming ability to hold a long position for three to four years, seems very logical. The current sideways market looks to have a period of about 7 to 8 years, vs. the '62-'83 market's 4 year period (period = time from high to next high, or time from low to next low).

These opinions result from technical analysis, but the data are simply a reflection of human sentiment and imbalances of supply and demand. When multiple methods of market analysis all come together, it is time to pay attention.

2008 Oct 13 10:19 AM

[sumosama:]

comma splices!!! Aargh!!!

2008 Oct 14 01:10 PM

[Muzie:]

I love how everybody is looking at squiggly lines today and believe they can predict the entire gamut of human experience for the next thiry five years from that one line.

Wake up, people, look away from the monitor charts. There's a real world out there, and believe it or not, some of us plan on making the world a better and wealthier place 35 years from now, rather than standing aside and hoping for the squiggly line to stay flat.

2008 Oct 18 11:42 AM