Sunday, July 29, 2007

Are We Making A Bottom in the Stock Market?

This has been the most common question asked of me by traders over the weekend. There is both the sense that we could go much lower in a washout (a "Black Monday" scenario) and that we could be seeing an important bottom in the making.

When we get to market junctures such as the one at present, I like to consult the historical record. While the present and near-term future is not guaranteed to follow the past, I know of no better guide than actual market experience. What has happened in the market after we've had similar bouts of selling?

For this investigation, I looked at the past ten trading sessions in the NYSE and found that, if we measure volume in declining issues as a proportion of volume in both advancers and decliners, then we see that there has been an unusual concentration of volume in the falling stocks. Indeed, over 70% of volume in the past ten sessions has occurred in declining stocks.

To give a bit of perspective on this one-sidedness, we've only had 75 other occasions since 1960 (!) in which 70% or more of the volume has been in declining stocks over a two-week interval. That is out of almost 12,000 trading days. Stated otherwise, the current market is in the top 1% of all market occasions since 1960 for bearish concentration of volume.

Let's take a look at the most recent market occasions and what happened afterward:

The most recent occasion of bearish concentration of volume lasted for 2 days in July, 2002. The S&P 500 cash market ($SPX) was significantly higher five days later by about 10%.

We also had a series of four days with very bearish concentration in September, 2001 following the 9/11 terrorist attack. $SPX declined for several days by about 7% following the first such day, before ultimately rebounding over 10% in the next two weeks.

In August, 1990 there was a single day in which over 70% of volume was concentrated in falling issues. The S&P 500 Index was up more than 5% over the next two weeks.

For a series of three days in October, 1987--the infamous market drop--we had a similar concentration of volume in falling issues. After the first instance, the market dropped about 20% further before eventually rising over 13% in the next two weeks.

For a single day in September, 1981, we saw an extreme negative volume concentration. The market was higher by over 7% in the next two weeks.

Similarly, we had a single occasion in March, 1980; the S&P 500 Index was down by about 3% over the next five trading sessions and down less than a percent two weeks later.

Two occasions in October, 1979 (the second "October massacre") led to an initial drop of about 1%, followed by a 1% rally over the next two weeks.

During the first October massacre in 1978, there were 8 straight days with heavy negative volume concentrations over the prior ten days. The market dropped more than 4% following the initial occasion and could not break even ten days following the last occasions.

In late July and early August, 1975 we had four days in a row with the bearish concentration. The market fell 2% following the initial occasion, but was down two weeks following all instances.

August, 1974 saw a string of six negative volume concentration days and late June/early July of that year had seven such instances. Both times the market initially dropped 3-5% over the next week, before eventually rallying more modestly.

If we look across all 75 instances, the market was up 41 times and down 34 after a five day period for an average gain of .87%. When we look three weeks out, however, the market was up only 36 times and down 39 times, for a subnormal gain of only .08%.

Many of the weak markets bounced before retracing those gains, but we also find many instances in which weak markets became significantly weaker before putting in a short-term bottom. Out of the 75 instances of high downside volume concentration, 51--about 2/3--traded lower some time within the next 20 trading sessions. A total of 26 of the occasions *never* traded higher within the next 20 sessions.

That having been said, if you know your market history, you know that the vast majority of these occasions occurred relatively late in bear market moves. Most of those market occasions were good long-term buying opportunities, short-term weakness notwithstanding. Investors would have done well to buy stocks in 2002, 1990, 1987, 1981, etc. Most of these markets were nicely higher one year later.

That tells me that the current weakness offers risk as well as reward for shorter timeframe traders, but also is a heads up for investors seeking value. The concentration of volume in falling stocks suggests that good issues are being trounced with the bad. This creates opportunity in the long run, even as the historical record shows uneven performance near-term.