The Case for a Market Bottom

09/02/2008 12:00 am EST

Focus: OPTIONS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of the Option Advisor, says there’s evidence the market may have bottomed in mid-July.

There are numerous indications that the market in general, and the financial sector in particular, put in a bottom on July 15th; this despite ongoing widespread fears that the credit “crisis” will result in the destruction of some major financial institutions (beyond Fannie Mae and Freddie Mac) and this will contribute to an economic implosion that could approach depression levels.

What are the indications that the market may have reached a “liquidation bottom” amidst all the screaming headlines warning of “danger and disaster”?

1. The CBOE Market Volatility Index (VIX) managed to cross the 30-threshold, peaking at 30.86. But more importantly, the VIX futures curve turned distinctively negative, which means that the pricing of front-month VIX futures became much more aggressive than that for the “out months”. Such situations have been consistent with market bottoms over the period these futures contracts have been trading.

2. Earlier this month, we completed a streak of nine consecutive weeks of bears exceeding bulls in the Investors Intelligence survey, the longest such streak since the one that ended in February 1995 ahead of a 30% market rally over the course of the next year.

3. Standard & Poor’s Depository Receipts (Amex: SPY) volume reached record levels for the weeks ending July 11th and July 18th. SPY volume historically expands on fear-based pullbacks.

4. New York Stock Exchange short sales as a percentage of total weekly sales shot up to a record 35% for the week ending July 18th.

5. The S&P 500’s intraday low on July 15th was 1,200.22. The 1,200 area has been very significant over the past decade. It was resistance as the market was topping in July 1998 ahead of a major plunge as well as in early 2002, and it was supportive in 2005 and 2006.

6. As for the financial sector, which had led the market decline, put open interest and short interest skyrocketed to record levels in the preceding months, and volume on 7/15 in the Financial Select Sector SPDR (Amex: XLF) soared to 60% above its March record high.

As we all know by now, the hedge funds got caught with massive long positions in the commodities sector and massive short positions in the financials, and the forced unwinding of these positions as the financials staged a “V-bottom” resulted in some very heavy losses.

While I don't know how the “fast money” hedge funds are now positioned in these two sectors, I’m quite sure they are not positioned for a major rally in both commodities and financials. Yet, I believe that such a rally is likely for the remainder of the year, which could be further fueled by the unwinding of hedge fund shorts.

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