A Bold Forecast: Wednesday Was Not The Bottom

Includes: DIA, IWM, QQQ, SPY
by: Cam Hui, CFA

Wow! Mr. Market certainly took us for a wild ride on Wednesday. At one point, the Dow cratered over 400 points, but closed the day down only 173, or 1%.

At first glance, the market action seemed to have the elements of a capitulation bottom. As the chart below shows, two of my trifecta of bottom spotting indicators are flashing oversold signals (see the discussion in A tradable bottom and my most recent post In the 7th inning of a correction). In addition, the SPX kinda, sorta formed a doji on the day, where the close was approximately the same level as the open. Such Japanese candlestick formations are often indications of market indecision and can mark reversals. Moreover, the pattern where the market trades falls at the open and rallies near the end of the day to close at or near the high is also a sign of bearish exhaustion - another bullish sign.

A bold forecast

Despite these promising bullish signs, I will make a bold forecast here. Yesterday, Wednesday, October 15, 2014, was not the bottom of the market decline. While the market is very oversold and we are likely to see a market bottom within days, the bulls will have to be prepared for more pain in the near future.

Looking beneath the surface, the tape did not feel right to me for a capitulation bottom. Consider this chart below of the relative performance of the different major sectors against SPY for the day. If I told you that the market action in a day was marked by downside leadership was in Financials and Utilities, and traditional high octane sectors and groups, like small and mid caps and NASDAQ, outperformed, would you expect to see a day where the major averages were down over 2% at the worst points of the day? These are not the normal signs of a panic capitulation sell-off.

Given the change in technical tone of the market, where the SPX violated the 200 dma without even a pause, we can definitely conclude that we are not in the steady uptrending market of the past two years. Perhaps better analogues of the current market weakness can be found in the pre-2012 period, in the market sell-offs of 2010 and 2011.

I went back to those two years to see what happened during the market weakness episodes of that time. As the chart below of 2010 shows, notwithstanding the unusual Flash Crash, there were two instances circled in red of dojis or hammers, where the market fell at the open but rallied to close above the open. Neither case marked the bottom of the decline.

Here is the chart of the SPX in 2011. Same thing - neither instance marked the bottom of the decline.

With the caveat that the sample sizes are small, these charts nevertheless show that the kind of market action we saw today, especially with the unusual nature of the leadership, do not indicate that the stock market bottomed today. For a true capitulation bottom, we may need to see a "margin clerk" market, where everything goes down on high volume, all sectors including gold, and correlations converge to 1.

You know when you go to the hospital for a medical procedure that you know to be painful and the doctor tells you, "You're going feel a bit of a pinch"? I am afraid that's what going to happen to the bulls for the next few days.

Disclaimer: The opinions and any recommendations expressed in this blog are solely those of the author. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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