The Worst Bear Ever?

10/20/2008 1:00 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Larry McMillan, editor of The Option Strategist, says the market is the most oversold he’s ever seen, but it’s still not giving buy signals.

Is this the most oversold (or most bearish) market ever? This is arguably the worst bear market in history because of its speed, although veterans of 1932 and 1974 may validly disagree. I’ve been trading since 1970, and this one seems worse than 1973-1974, but I’d rate them as pretty close.

The difference was that 1973-1974 was at the end of eight years of bear markets, and most individuals had long since left the stock market for other investments. This market still has everyone trapped in it, thanks to the low- volatility, heavily manufactured bull market of 2003-2007.

The market has plummeted in a true waterfall decline. Breadth has been abysmal as declining issues have swamped advancing issues. The NYSE-based breadth oscillator [has traded] at an all-time low.

Both VIX and VXO [volatility indexes] traded at new all-time highs on Thursday, October 9th.  A sharp downward reversal in VIX is a short-term buy signal for the stock market. There have been a couple of those recently, but the resulting market rallies were so short term that they weren’t even tradable. Typically, once VIX gets this high, it tends to stay high for a while.

Another indicator that we watch is the difference between the two volatility indices. In bear markets, VXO tends to rise faster. When the difference between the two reaches four points or more, the stock market is extremely oversold. (Recently, the two traded as much as 13 points apart, intraday!) If the differential shrinks to four points or less, that would clearly be a buy signal, in my opinion.

This decline without rebounds is being caused by massive margin calls, causing unwinding around the planet. The selling has reached historic proportions. There literally is a “run on the market,” as investors worldwide are dumping stocks. It seems that the major catalyst for this selling is the fact that the newest large banks—primarily J. P. Morgan, Goldman Sachs, and possibly Morgan Stanley as well—have issued massive margin calls to hedge funds and other professional traders who use these banks as prime brokers.

In this illiquid environment, where all manner of exotic securities literally have no bids, the only place to raise the cash to meet margin calls was to sell stock. That is what really set this market over the edge—as the first notice of these calls were issued on October 2nd and 3rd.

Eventually, when they have run their course, there should be a strong oversold rally (if anyone has the temerity to buy anything by then). Meanwhile, remember that however strong such an initial oversold rebound actually is, it will not be the bottom. Eventually, there will be a retest somewhere down the road.

There are no intermediate-term buy signals, but there are massive oversold conditions. The chart of the Standard & Poor’s index is negative, although an oversold rally could carry as high as the declining 20-day moving average (currently at about 1130).

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