by Barry Ritholtz
March 20, 2001
After a long, cold Winter, Spring has finally arrived. Has the change of seasons brought a change to the market’s tenor? Based on several key metrics, I believe it has – we are finally seeing the end of the sell off.
Ten factors are urging me in this direction:
First, the calendar is finally working in the favor of long positions. By April 15, all tax related selling will be over. This includes individual investors raising cash to pay capital gains taxes from Q1 2000, and institutions doing the same to meet redemptions after their long slide.
It’s a big positive akin to the “January Effect” – when that selling pressure finally lets up, the market is free to bounce.
Second, history shows it’s utterly futile to “Fight the Fed.” Whenever the Federal Reserve has cut interest rates three times in rapid succession, the markets have responded positively. In 12 out of 13 instances over the past century – the exception being the 1930 cuts during the Great Depression –equities have seen average gains of 20 percent over the ensuing 12 months.
Is today more like the exception in 1930, or the other dozen cutting cycles? (You already know my answer).
Third, two of my three technical downside targets have been met. I had pegged potential major downside Nasdaq moves at key support levels: 2520, 1850, and 1525. For now, we may have found support right here between 1800-57. At most, there’s no more than a 50% probability on the 1525 downside target on the Nasdaq. The Dow could certainly see 9100, and its, at best, even money to see 8200. Enough to be cautious, yet still selectively start legging into new long positions.
Fourth, the Arms Index 10 day moving average has flashed a critical buy signal. The Arms Index is a technical indicator which calculates the quotient of advancers vs decliners, and then divides that by the quotient of the VOLUME of advancers vs decliners.
It measures how much buying or selling is required to “move the markets.”
In the past 40 years, this indicator has accurately called a market bottom within 20 trading days following its major signal – 11 out of 12 times. Even that one exception accurately suggested a major trend change; For a more complete discussion of the Arms index, see Aaron Tasks discussion: http://www.thestreet.com/markets/aarontaskfree/1351978.html
This most recent Arms Index signal implies that only enormous selling can move us downward. In fact, it took a billion shares after the Fed’s announcement on March 20, and that wave of selling only moved the Nasdaq from plus 25 to down 100 or so -- between 2:15 and 4:00 pm.
Fifth, a number of analysts whose models I respect – notably Abbie Joseph Cohen of Goldman Sachs and Dr. Ed Yardeni of Deutche Bank – have noted that as of March 18, the S&P500 is 5% undervalued; By March 22, it was closer to 10% undervalued.
Both use valuation models comparing consensus earnings estimates of the S&P500 to the 10 year treasury bond yield. At these undervalued levels, we are geared for a major snapback rally.
Sixth, all three newsweeklies – Time, Newsweek, and U.S. News – have stories on the recession or bear market on their covers. This has been a classic and highly correlated contrary indicator over the years. As I explained in "Contrary Indicators Tip Off Discerning Investors in Year 2000," (http://www.thestreet.com/comment/cfeatures/1242603.html), by the time the non-business press realizes the significance of the economic story, the wheel has already begun to turn.
Seventh, the defensive issues are getting hit hard; Phillip Morris (MO) and American Express have been selling smartly. MO is down 15% in a week from its recent highs – that’s a strong positive. Even Berkshire Hathaway (BRKZB) has been soft. When money rotates out of defensives, it finds its way into the “newly cheap” stocks from the most recently bloodied sectors, and the stocks with the best relative strength. That’s a positive for the beaten up Nasdaq.
My eighth piece of evidence is the Put/Call ratio. March 22’s action saw a very significant number of Put buyers come out of the woodwork in already beaten down tech stocks like Intel, JDSU, Sun and other Nasdsaq 100 issues. It’s another good contrary indicator when excessive pessimism shifts the Put/Call ratio too far towards bearishness.
Nine -- It’s become apparent that much of the bad news is fully priced into a lot of stocks. Micron (MU) postponed for a week its earnings announcement – and the stock rallied smartly. If management had done the same thing last quarter, the stock would have been cut in half; Instead, we saw a nearly 15% rise. Earlier this week, Corning’s (GLW) lowered guidance was met with a yawn. Then Microsoft rallied smartly after Goldman lowered growth numbers today.
The positive reaction to bad news suggests that the worst of the negativity is “already priced into stocks.” That’s a healthy part of the bottoming process.
My tenth and last piece of evidence is the historical time and price actions in Bear markets. All three major indexes – the Dow, the S&P, and the Nasdaq – have lost over 2 years worth of their gains, and over 25% off their total valuations. According to Ned Davis research, the average Dow Bear market lasted 363 days and sold off 25%; On the S&P, its 13 months and 28%.
We’ve hit those historical averages. While that’s not conclusive, it’s another piece of the puzzle suggesting that the end of the sell off is nearing.
A final thought on bottom calling: Far too many “gurus” have wrongly declared a bottom over the past few months. I’m not a guru, and I’m not looking to make such a call.
My training as an attorney forces me to take a different approach: I look at the historical evidence – the precedents, so to speak – and when they align strongly on the side of a reversal, I feel compelled to bring it to your attention.
Historical evidence strongly suggests that the selling is mostly washed out. After the April 15 deadline passes, I’m hard pressed to find additional negative catalysts.
These factors make me cautiously Bullish. I’d put 20% of fresh money into the market right here, and scale in another 20% as we approach April 15 – or at the attractive valuations if we’re lucky enough to hit Nasdaq 1500. An upwards move through Nazz 2000 -- from either here or lower – would also be very bullish. That’s where I’d put third leg into select equities.
The last 40% of equity investment capital should be reserved for when the picture clears, for specific opportunities as they present themselves, or for a retest of the March 22 lows.
Barry Ritholtz is the Market Strategist at Weatherly Securities. A prior version of this was distributed to portfolio managers, brokers and traders on March 20th. At the time of publication, Ritholtz was long Corning, EMC, Goldman Sachs, Micron and Microsoft.
Copyright © 2001 Barry L. Ritholtz, All Rights Reserved worldwide. May
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