Anatomy Of A Market Collapse
Via Michael Naso of FBN Securities,
On August 14, I penned a Daily Missive which outlined the various fundamental and technical characteristics of each of the three stages of a standard rally such that one could use the blueprint in identifying an imminent top which I officially called for on September 7. The piece received more positive feedback than most such that the 6.6% drop in the S&P 500 from the September 14 peak merits a similar commentary on the different phases of a market pullback. The chart below leverages statistics compiled from the prior decade from various selloffs (i.e. > 7%) which have produced consistent patterns that help traders ascertain the potential depth and duration of the current downward move:
Negatively skewed prices mark a key hallmark of selloffs in that stocks descend much faster than they rise. Although the duration of a rally may last months or possibly years, a soft market may only exist for a few weeks or less. Consequently, when a decline lasts for several months or longer, such as the collapses of the Dot Com bubble and the financial crisis, shares suffer massive dislocations.
No sustained drop in equity prices ever fits perfectly into one of these three pockets; however the current pullback appears close to crossing from Mid-cycle to Exhaustion. The average monthly NYSE Closing TICK has dipped to +87 which I would classify as oversold albeit not excessively so. This represents my most reliable buy signal such that without this trigger, I will remain negative for the days ahead even though the average intraday TICK has fallen solidly below +15. Open interest has now increased by 150K E-Mini equivalent contracts over the prior two sessions indicating that long-short managers have panicked somewhat and subsequently reduced the beta of their portfolios. The average intraday range over the prior week has increased to over 20 handles while the difference in intraday volatility between the cash index and the E-Minis decreased sharply yesterday.
Fundamentally, earnings have stumbled, but have not worsened as we have progressed through the reporting season. The economic data has improved, but I anticipate a negative inflection point in these statistics as the effects of Hurricane Sandy and the fiscal cliff start to make their presences felt over the next several weeks. Most analysts foresee the FOMC will supplant Operation Twist, which expires on December 31, with unsterilized Treasury purchases totaling $45B. While the fiscal cliff looms as a massive exogenous shock into year end, additional selling may entice buyers with attractive valuations since Congress and the President still has nearly two months to arrive at some resolution. I expect the risk associated with the event will not heighten dramatically until after the Fed meeting on December 12 such that investors would judge a forward P/E that drops to 12.0x in the near term as reasonably cheap to engage in bottom fishing.
Extrapolating the current landscape from this historical reference yields a market not too far off from a significant trough such that I currently estimate a bottom for the S&P 500 between 1355 and 1360. For many, the current index level is close enough to this target to start picking away from the long side. I am a bit more demanding when calling for an official turn, such that I will use my aforementioned test associated with the average monthly NYSE Closing TICK as my guide. Fundamentally, if and when I do call for a reversal, it will be modest and cyclical within the context of a larger pullback that arises from a butting of heads in trying to assuage one of the most serious fiscal crises facing the Federal Government in its history.