Ready for a Rebound?

10/23/2008 9:50 am EST

Focus: MARKETS

Sam Stovall

Chief Investment Strategist, CFRA Research

A frequent question asked of many strategists on Friday, October 10th, was, “If that was the bear-market bottom, should I buy into this bounce? If so, how long might it last and how high could it go?”

I don’t think anyone knows for sure if the October 10th low for the Standard & Poor’s 500 index will eventually be the bottom for this bear market. (On that day it closed at 899.22, but hit an intraday low of 839.80. It closed at around 896 on Wednesday—Editor.) It was accompanied by extreme levels of investor pessimism, which from a contrarian standpoint is a good thing, in our opinion.

An end to a bear market is traditionally gleaned from price action, rather than an actual improvement in fundamentals. Technicians also look to sentiment indicators to anticipate the initial bear-market bottom, and the likelihood of a successful re-test. Since we have yet to record a possible market low on a closing basis, Mark Arbeter, S&P’s chief technical strategist, has been looking at several investor sentiment indicators for signs of excessive pessimism. He has found many, from put/call ratios to the overwhelming bearishness of newsletter writers.

On Monday, October 6th, he noticed that NYSE new lows divided by total issues traded spiked to almost 60%, which was an all-time high, and beat the 54% that was logged the day after the 1987 crash. He thinks this is clear evidence of panic by investors, which is another sign a bottom could be near. Because stock indices have fallen off a cliff, he believes there is a chance that we see a large counter-trend rally, as there is little chart resistance between the current level and 1200 on the S&P 500.

Taking Mark’s cue, I have looked at the two-month average of daily high versus low percent changes in the S&P 500, and find that we have broken above the historical level of excessive volatility (which is measured by two standard deviations above the mean). This breakout is meaningful, in my view, since a peak in volatility and bearishness has occurred within one month of major bear-market bottoms since 1960. In addition, currently 98% of all sub-industries in the S&P 500 have declined in the past six months, equaling the extreme bearishness seen on 9/27/02.

So, if this is a bear-market bottom, how much upside could we see in the initial recovery phase, and then how much might we give back during the anticipated re-testing process? Well, if history is any guide, we may experience what I call a “Moses movement,” since initial recoveries off bear-market bottoms have occurred over an average of about 40 days and have retraced an average of one-third of the bear-market’s overall point decline.

Following this recovery, however, the market typically gave investors another opportunity to buy into stocks at a lower price, as a retest of the bear-market bottom developed over an average 19 days and removed an average 7.1% of the overall market’s value.

In the past 50 years, the S&P 500 has experienced nine bear markets, excluding the current one. S&P defines a bear market as a peak-to-trough decline of at least 20%. In two other periods, the S&P 500 fell more than 19%, but did not eclipse the 20% threshold. Using these 11 market declines as guides, I found that once a bottom has been put into place, the S&P 500 experiences a fairly swift and sharp surge in prices.

The table shows data for these market declines, recoveries and re-tests.

Typically, the S&P 500 has recovered about 33% of the point decline experienced in the prior bear market in approximately 40 days following that bottom. Of course, not all recoveries were the same. Some initial recoveries gained back more yardage than others. Following the 1982 bear market, for instance, the S&P recovered 59% of the points lost in the prior bear market before taking a breather.

In general, retests occurred in about 20 days following the recovery peak, and ended up giving back an average 7% of the market’s overall value. Some retests were mere hiccups in ongoing advances. Following the mega-meltdowns of 1973-74 and 2000-02, however, the retests were more gut-wrenching than most as the S&P 500 suffered through declines of 13.5% and 14.7%.

So, what does all of this mean to us? If the averages hold true—and there’s no guarantee they will—the S&P 500 could see a recovery from the near-900 low to approximately 1120 by mid-November, and then re-test the early-October bottom by declining to around 1040 by early December. I checked these levels with Mark Arbeter and his response was, “Those levels represent prior areas of support and resistance for the market. Isn’t it funny how those things work out?”

Of course, all of this is speculation—not only the magnitude and duration of the recovery and retest, but also whether this indeed comes on the heels of the bear-market bottom. With so much riding on the resolution of the credit crisis, combined with the fallout from the weakening global economy, we may again find—as we did in mid-March and in mid-July—that these supposed “bottoms” are merely resting places before the ultimate low.

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