Excellent Analysis From TheBestNewsletters.com

Its been a while since I read something about the stock market that made sense. Enjoy the post.

As longtime readers know, we don’t put much stock in making market predictions. We’ve borrowed Marty Zweig’s famous quote many times in the past and think it is once again appropriate today. Marty said “Those who rely on a crystal ball in investing will wind up with an awful lot of crushed glass in their portfolio.” In our humble opinion, truer words were never spoken. And it is for this reason, that we spend our time focusing on what IS happening in the market instead of what we think ought to be happening.

However, when times get tough, it is actually very helpful to have some sort of a historical guide to assist us in discerning what might be coming next. Think of this as being prepared from a long-term perspective. And as another famous saying goes, “history doesn’t repeat, but sometimes it rhymes.”

Make no mistake about it; what we are seeing today has never happened before. In short, we are experiencing a paradigm shift in our financial system and the deleveraging and restructuring that is occurring will take time to play out. So as our first point this weekend, please, please, please don’t expect the stock market to suddenly snap back and “be all better again” in short order. The road to recovery is going to take a while.

Yet, at the same time, it is important to recognize that we have seen this type of market action before. And it is for this reason that we have been consulting our Crash Playbook with regularity these days. So this weekend, we thought we’d review what we know about the aftermath of market crashes and what we are looking for next.

The Waterfall Decline

We may not know exactly what lies ahead in the stock market. However, we can with utmost certainty say that what we’ve seen over the past few weeks is a crash, or what is also called a waterfall decline. Believe it or not, this type of action is not all that uncommon and often marks the bottom of bear market declines (as does the month of October).

As we’ve discussed recently, this type of drop is violent in nature and occurs over a short period of time. And I think we can all agree that the decline of -22% in the DJIA over the first 8 trading days in October certainly qualifies – so let’s go ahead a make a checkmark here.

Crashes are also accompanied by several other factors. First, there is usually massive volume as investors rush to the exits at the same time (check). Next, the reason for the decline produces fear, panic selling and mind boggling volatility (check, check, and check). In addition, you will see the stock market on magazine covers and all over the news (check). Then the forced selling (aka margin calls) usually exacerbates the decline because there are no buyers around (double check). You will also see massive oversold readings and extremely negative sentiment indicators (check and check – current oversold and sentiment readings are matching up with those seen in 1974 and 1987). And finally, all of the above happens so fast that it is nearly impossible to maintain your bearings in the market (big, bold checkmark – the Dow can move more than 500 points in 5 minutes these days!).

The Bounce and Retest

The Crash Playbook tells us that what usually comes next is a dead-cat bounce, which allows investors to breathe a sigh of relief. This blast skyward is usually short lived and violent in nature. And in looking at the current market, we are pretty confident that the Dow’s bounce of 24% from mid-morning on Friday, October 10th through the first 5 minutes of Tuesday October 14th qualifies as a classic dead-cat bounce.

Next comes the all important “retest.” And frankly, this is the money move. You see, to those without a Crash Playbook, the retest of the lows appears to be a resumption of the waterfall decline. This causes fear to return in a big way and anyone who has not yet sold will panic and do so here (cries of “I can’t take it anymore” will be prevalent among this crowd of sellers). Ideally, we would like for this decline to occur on lighter volume, which would indicate that the selling pressure has finally abated.

The hard part, of course, is the retest phase is scary! Oftentimes the recent low is actually violated, which is unnerving and will bring out technical selling on the “breakdown.” However, as long as the volume does not increase and the breadth of the market isn’t as bad as it was during the waterfall, a minor and short lived breakdown is actually acceptable behavior.

However, IF the market averages break to new lows on strong volume and intensely negative breadth, all bets are off as this action would likely indicate a new leg of the bear is underway.

So, IF we see a new down leg begin, which is certainly a possibility given the uncertainty of what’s still on bank balance sheets, the unwillingness of banks to lend, and the redemptions coming out of funds, you will need to hit the reset button on our crash pattern and start looking to make checkmarks all over again.

The Recovery Game

IF the low of October 10th holds up, the good news is that we can then start to play the recovery game. But, before you get too excited, we should point out that the early phases of a market recovery are anything but easy. Investor fear persists and the media will likely continue to pound the doom and gloom theme.

However, THIS is the time where it pays to really understand what is going on. As we have pointed out before, Ned Davis research tells us that one-half of a new bull market’s gains occur in the first one-third of the move. And remember, according to Ned’s qualifications, the average bull market gain since 1900 has been about 80.5%.

The point is that if you are a true investor, you cannot afford to wait until things “feel good” again before you return to the market. In short, by the time things calm down and everybody in the media is comfortable again, the bull move could easily be one-half over.

So, since things will undoubtedly “feel bad” during the bottoming process and recovery phase, you need some sort of a signal to guide you back into the game. As we’ve mentioned a time or two lately, we will be looking for a surge in the breadth statistics of the market. We’d like to see the 10-day ratio of advancing stocks to declining stocks move above 1.91. We’d like to see the number of industries that are technically healthy improve quickly to over 65%. We’d like to see a couple of days where the up/down volume (on operating companies) is greater than 9 to 1. And we’d like to see the number of stocks above their 50-day moving averages become positive.

It is also important to recognize what works coming out of a bear market bottom. While playing the conservative sectors such as health care and consumer staples may sound logical due to the fact that they are usually less impacted by tough economic times, these are NOT the areas to be in once the market has bottomed and a recovery is underway.

No, once a bottom has been established, in the past it has paid to play the higher beta areas – namely technology, consumer discretionary, industrials, and especially in this case, the financials. Why does this work? First, because the stock market discounts the future and when stocks bottom they are looking ahead to better times. And second, since the higher beta areas also get beat up the most during the bear market, they have mean reversion (i.e. the catch up game) working for them.

Let’s Be Careful Out There

Although we do believe the chances are good that we saw the low on Friday, October 10th, it is not time to get aggressive – yet (unless you are a very active trader – then you can start buying the dips here). Yes, we’ve seen a dead-cat bounce. Yes, we are seeing a retest. But, at this time, we do not have confirmation that the retest has been successful.

So, with the Crash Playbook by our side our plan is to continue to be cautious. However, we are leaning toward the buy side at the present time – at least for an intermediate-term trade.

Wishing you all the best for a profitable week ahead.

Source: By David D. Moenning