Oversold Extremes and the Case for an October Low

Retro style image of a rural signboard with two signs saying -  Sell - Buy - pointing in opposite directions.

Is this a bottom and what do buying opportunities look like after a quick panic?

Oversold Extreme Indications:

This is as oversold as it gets basis sentiment. Just before the market plunged almost 10% intraday over the past week we were already pointing out to readers that oversold conditions were appearing despite the very normal market pullback as we looked for a pre-Fed meeting time to buy if prices corrected into August or September. Thanks in large part to the surprising Chinese economic weakness and resulting Oil and commodity collapse devastating emerging market economies, we have our long overdue correction.

To the question of how oversold are the indicators: there is no doubt we have quickly moved to multi-year if not all time record extreme oversold conditions that in some cases surpass the far more devastating Bear Market lows of 2002 and 2009.

The 5, 10 and 20 day equity put/call option sentiment ratios have easily jumped to multi-year extreme levels of negativity. Readings above 0.78 are rare and always coincide within days of at least a short term stock market bottom and likely signal a broader low in the weeks to follow. Since the recent 3 day rally began Wednesday August 26th the market is already 15% higher.

August put call chart

The compilation of momentum and sentiment indicators making up the CNN Money Fear and Greed Index have also fallen to an extreme level that was last achieved right at the bottom of a 10% correction last December. As with most sentiment and momentum indicators, the degree of extreme oversold or overbought levels doesn’t imply a larger rally or greater decline is coming, only that a trend reversal is very overdue.

Fear & Greed Aug 2015

Market-Harmonics.com has many worthwhile indicators. The Nova/Ursa level measures sentiment through the buying and selling of Bullish and Bearish mutual funds. The current negative extreme far exceeds any negative Bear Fund buying on record going back over a decade. The Nasdaq Sentiment chart on the right is also fast approaching all time record extremes indicating that a trend reversal from this correction is near.

Nova Usra Aug 2015

Nasdaq Sentiment Index Aug 2015

 

 

 

 

 

This 10 year chart below measures sentiment trends using index options of institutional traders and equity options of average investors. The August 25th oversold sentiment extreme seems unlikely to be exceeded again as it surpassed the nadir of the 2008/2009 Bear market. This doesn’t mean an explosive Bull market is ready to resume, but that a short term low has arrived and a longer term bottom is coming in the weeks or months ahead as was the case in late 2008 to early 2009. Such extreme sentiment is a bit surprising when considering how modest the price correction in the stock market has been and how brief the panic selling has persisted. We would add that another sentiment measure not shown here is through Investors Intelligence (II) who surveys professional advisors. II surveys this week (August 28th)  indicate the percent of Bulls (31.6%) has fallen to its lowest level since 2010 and 2008, while advisors expecting a correction have soared to equal their highest readings in history at 46%.  With so many already sold out, short and looking for lower prices, a sideways to higher price trend is the most likely. 

OBSG Aug 2015

These extreme technical oversold conditions that favor future optimism and Buy points need to balanced by the fundamental realities of contracting emerging markets and OPEC economies and a slowing China along with an energy sector which can trigger debt defaults in many parts of the world. Thus far there are hopeful signs of new order growth in Europe as well as a US labor market which is employed fully enough with record job openings that are spurring consumer expenditures and exceeding expectations on the upside. So the consumer driven western economies are edging higher while export production economies like Brazil, Canada and China are teetering on the edge of serious financial recessions. Who will lead whom? Typically the Western consumption driven economies and their service sectors lead the world: look for commodities to move higher in 2016-2017 as the emerging markets bottom.

One final note about the current correction: we will watch 3 other markets for clues as to the next phase for US stocks. Strength in the Yen, weakness in Oil, a negative Junk Bond divergence and any break of recent lows in Chinese stocks would all be warnings of a further panic in US stocks. The reverse of these indications are also true.China stock market Aug 2015

Junk bond diverge SPY

What will a bottom in stocks look like?

After the sharp selloff over the past 2 weeks confirmed that a noteworthy correction or “submerging” emerging market panic was underway, we wanted to explore past market corrections of significance for clues of patterns that may repeat. History may not be repeated, but it often rhymes!

2015 panic drop

The current August 2015 correction began as many historical pullbacks have: a summer top followed by 1 to 2 weeks of price capitulation and then a sharp 2 to 3 day bounce. What next? In 2011 the final low occurred about 7 weeks after the initial panic low. Such a pattern would target the week of October 12th for a final low.

2011 flash crash

During the major Bear market of 2008 there was a period when prices also behaved in similar fashion. An August top punctuated by another one to two week panic and an initial 2 day rally looks familiar. We can watch other markers in coming days and weeks to observe if this price pattern evolves with more or less similarity. One commonality is that Oil prices were collapsing during the panic phases of 2015 and 2008. While this overall pattern would be more negative than most scenarios if extrapolated out a few more months, what we do like is the classic sideways pattern as shown in 2011 after its initial panic low. This 2008 pattern could indicate a secondary low in early October – similar to 2011’s chart.

2008 sp panic

Finally we will comment of the classic stock market panic of 1987. Like 2015, the 1987 panic was preceded by an August top that led to a similar couple week decline with both time periods punctuated by 5 day panic phases and 2 day rallies. We again include several markers to watch for with the main conclusion that a secondary final low is due during the 1st half of October – this aligns well with 2008 and 2011 charts shown above.

1987 panic chart

 

Price patterns created by repetitive general psychological investor reactions to price panics can be interesting and useful. Often these panics occur when there is no economic basis in reality.  The Black  Monday 1987 panic, the 1998 Asian Contagion panic and the Flash Crash of 2011 are a few panics that stand out as periods where investor psychology changed radically without any significant economic correction in Western economies. Thus far Western economies are subdued but growing with Auto sales and general consumption tends leading to modest job growth and rising rates of consumption. Will China and panics abroad bring Western economies closer to a recession or will the US and Europe pull the Global export market higher once again? We continue to favor a continuation of the US expansion over the next couple of years with a 90% stock market exposure for long term equity investors. By year end global commodities, oil and stock markets should have bottomed longer term as more positive trends start to reemerge.

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