Bottom Quest

The worst thing about last week is that the there are so few signs that a bottom is near.

Both the mainstream press and the blogosphere offer some excellent reading this weekend. There's also large amounts of windbag speculation and a fair amount of bellyaching. While this all makes for titillating journalism, an evidence-based approach to the market tends to be more productive for your portfolio.

As investors ponder a sea of red, below are five sets of market-based observations:





1. Panic

All rumors to the contrary, there was no evidence of panic selling this week. Even though the Dow shed 585 points in its worst week since 2003, trading was orderly, and from an historical perspective, the declines were chump change. This correction might accelerate into panic, but it hasn't happened yet.

On the left below is a chart of this week's NASDAQ. On the right is the Composite during the LTCM scandal in the summer of 1998. From the July high in 1998, the NASDAQ tumbled 33% in 12 weeks. In the last two weeks, the NASDAQ skidded a sickening 23% (imagine the Dow falling 3100 points in eight days).That felt panicky, especially because --doh! -- everyone thought the bottom had occured four weeks earlier (red arrow).








2. Bottoms

I received numerous e-mails, comments and questions this week about identifying bottoms. Of particular interest was whether the IBD100 offered an edge. The short answer is no, the IBD100 is essentially useless at calling bottoms. Most leading stocks are bloody stumps at market lows. Most recover; many don't.

However, other indicators are helpful. When these are used in combination, they're generally accurate (but look again at the red arrow on the 1998 NASDAQ chart just above).

While some are crying oversold! this weekend (and the odds for a ST bounce next week are actually pretty good), almost all of the popular "bottom finders" show a market still above a Queen-approved bottom. Below are three classic proximity alerts. There are others, but those aren't there yet either.

Despite the HUGE surge in New Lows this week, the blue 10-week on both the NYSE and COMPQ High-Low Indexes remains well above important bottoms. Below are 5-year charts of the High-Low Indexes, which include the Oct 2002 bottom as reference. Historically, the blue 10-week line crosses below 40 -- and even below 30 -- before a meaningful bottom is in.







The percentage of NASDAQ stocks trading above their 50- and 200-day is still high for a bottom. NYSE versions of this metric produce similar results.







NASDAQ market breadth as measured even by the unforgiving NASI is still above the rising trendline off the Oct 2002 bottom. NYSI offers a similar take.









3. Crash Alert?

Regular readers know that I'm hardly an alarmist, but -- believe it or not -- important market evidence emerged this week that raises the chance for a 1998-type stock market crash. First of all, we're not there yet and the odds are still long. [Re-read the previous sentence]. However, as I was preparing notes on this, I read Adam at Daily Options Report quoting Jason Goepfert on the same thing.

NYSE New Lows spiked to severe levels this week. In fact, New Lows have been this high only four times in the past 10 years. Making matters weirder, the NYSE is just 7.1% below an all-time high.

Also, the Dow wasn't the only chart that set a 4-year record this week. The VIX surged an ear-popping 43% to a new 4-year high, even though the SPX fell a relatively meager 4.9%. In fact, the SPX is up 6.9% from the March low, but instead of falling, the VIX has skyrocketed 160%!

The VIX is now parked 36% above its 10-day, a very unstable spread for the VIX. This week, option traders priced in something ferocious -- and still unseen. Given the New Low spike and a 24-handle VIX, my observations mirror Goepfert's about what stock market history says are three plausible scenarios:

--- the worst is over, and it's time to go long for the mother-of-all short covering rallies

--- this isn't just a correction, but the 4 1/2-year bull market is done and we're grinding lower into a lengthy bear market

--- the market detects something bad on the horizon, and we're about to see a rapid, convulsive selloff

The odds of a crash are long, but the market itself has thrown these scenarios onto the table, and not just the guys at Safehaven. Below is a 10-year chart of NYSE New Lows, along with the VIX.







4. Decent Economics

Juxtaposed against the doom and gloom is that the underlying US economics are surprisingly good. GDP is recovering, earnings are solid, valuations are nominal, employment is high, inflation is stable, and yields are low. If the market does plunge wildly lower, the economics point to it being a superb buying opportunity.

It's worth noting that, as subprime contagion and a rising yen threatens the US economy, the 2-year/10-year yield spread detects nary a whiff of recession. In fact, it's printing a 3 1/2-year low.








5. The Penalty Box

Below are the six worst performing groups this week. Housing is no surprise, but it's noteworthy that the metals continue to offer no refuge despite a dollar perched at the abyss. The next two losers -- energy and cyclicals -- are the most troubling economically. Utilities took out the 50- and 200-day in five sessions, and small caps lived up to their reputation as the style to avoid.







Pullbacks separate the wheat from the chaff, and one useful feature of this correction is that it started during earnings season. Companies that beat estimates are holding up better than the broader market, and the fresh earnings data is useful in preparing high-quality watchlists. No single investing strategy works for everyone, but stocks that pull back the least are typically the ones first out of the gate when the selling stops. Historically, they also run the farthest.

The week's best performers? Biotech, down 1.8%, followed by the NDX, down 3.9%.

Also, it's useful to track which stocks closed higher on a week like this. It's a great set of stocks with which to start a new watchlist.

--- On the NDX, 13 stocks closed higher on the week: AAPL, AMAT, AMLN, AMZN, BIIB, BMET, CELG, CHKP, GRMN, GENZ, ISRG, TLAB, VRTX, WYNN.

--- On the OEX, 6 stocks closed higher on the week : CL, IBM, MRK, PEP, PG, T

--- On the MID, 23 stocks closed higher on the week: ADVS, AJG, BEC, BRL, BRO, BSG, CCMP, CVD, DCI, EXBD, FFIV, GGG, GPRO, MFE, PAS, PLT, RFMD, ROL, RSG, VARI, WOOF, WPO

It should be a lively week ahead, as investors learn how good they are at following the ball in the other direction.

Hope everyone's having a great weekend.

best

dk