Have Equities Bottomed Out?

Hi, and welcome to this week’s edition of “I Wish I’d Written This Yesterday”. My original theme was The Markets Haven’t Bottomed But They’re Overdue A Bounce. The bounce is no longer overdue!

A day’s a long time in financial markets; on Tuesday the Dow (^DJI) rallied 5% (that’s 350 points). The FTSEDax (^FTSE) and the (^GDAXI) both ended up 200 points higher on the day. So now I’m going to look at what started this rally, how far it could go and whether it’s the real deal.

A Quick Re-Cap On Equity Markets

Since the turn of the year, the Dow and Dax have fallen by a thumping 28%; that’s on top of 30% plus falls in 2008. By comparison, the FTSE dropped by a half-decent 21% this year, following a 21% fall in 2008.

So, a miserable 2009. After a naively enthusiastic start to January, markets suffered almost a month of red candles (doesn’t it look so easy to trade now?)

But Markets Are Now Rising

The papers and screens are full of reasons and stories to attribute the rise to, but my humble view is that we were overdue a rise and it was going to be triggered by some mundane announcement, not too different to the headlines on many of the previous days.

As it was, Mr Citigroup (C) and Mr Bernanke gained most of the plaudits for the rise. Citigroup because it said that it was profitable in the first two months of 2009 and was on course for its best quarter since the third quarter of 2007. Beardy Ben added to the mood, assuring us that the US financial institutions wouldn’t be allowed to fail and that if the banking sector stabilised then 2010 would see a return to growth.

Also, lurking in the background is the prospect of the accounting practise of marking to market being ‘reformed’. Ironically, this is seen as equity positive as the banks will be able to make up prices for their toxic loans. Remember that this ‘back of an envelope’ pricing was how much of the earlier troubles began!

The Signs Were In The Charts

Regular readers know that I’ve been dabbling in long equity bets, but without the conviction to back the move with a wide stop loss. The reason I’ve been willing to spit into a strong wind was because of certain patterns in the charts. There were nods and winks but nothing firm, which in trading discipline means “It’s not time yet”.

One early sign I’d picked up was that the pace of the fall was slowing across markets; there were new lows, but the market wasn’t settling at the bottom (in candlestick world, there were a few spinning tops and dojis creeping in).

The other key warning was a divergence on the RSI (Relative Strength Indicator). Even though markets were setting lower prices, the recent trend in RSI was upwards. This is taken as an early warning of a trend reversal.

Neither of these were a strong buy signal, merely early warnings. But Tuesday’s large green candles will get a few traders excited, especially if Wednesday’s trade holds above the 14-day moving averages.

Is This The Real Deal?

Nah! I think there’s the possibility of a decent, perhaps even prolonged, bounce, but I reckon there’s more chance of the UK winning Eurovision than this being the bottom; and here are some of the reasons why:

1. Check out the VIX (^VIX):
   
   Sure, historically 50 (ish) is pretty high, but I don’t feel it’s reflecting enough fear for the bear market to be over. I’d feel more at ease if the index was up in the 70-80s.
2. The banks aren’t done yet. I’m not a banking analyst, merely an old cynic, but I reckon there’s one or two more kitchen sinks left to throw out. Granted there have been so many announcements that I may have missed it, but have we seen the full extent of exposure to credit default swaps yet? And how about old-fashioned business like unsecured loans and credit card repayments? With job losses increasing way above expectations I can’t help wondering if loan losses have been fully provided for.
3. Check out the charts. All the major equity markets are deep into a bear trend, with high ADX signals and 21-day moving averages pointing at Australia.
   
4. Capitulation. This, for me, is the biggie, and yes, it’s sort of linked to point 1 about the VIX. Capitulation Day is when the long-term holders finally throw in the towel. The thing is, the bottom only occurs when people stop trying to call it, which is a sort of paradox. For example, my original view was that the capitulation trade would see a re-test of the 2003 lows (close to 3260 on FTSE). But I’m not alone in that view, and the more accepted that view becomes the more investors will allow for it. So, perhaps the capitulation trade will be when the 2003 low doesn’t hold, leaving investors wondering where the hell the next level is. Madcap panicky selling will follow as traders’ risk tolerances are put to the sword. Then it’s time to buy.

How Am I Playing This?

For the moment, I’m still running a small long bet from 3619, and probably looking to add to it on a half-decent set-back. Yesterday’s intraday charts were showing equity markets as massively overbought. So we should see a correction and then we’ll find out if this was really a selling opportunity or whether this rally has the legs to carry on.

I think that after the horrific February, there’s scope for a proper rally, long enough to squeeze a few bears. The 21-day moving averages are a reasonable first target; that would be around 7200 on the Dow, 3850 on FTSE and 4000 on the Dax.

Risks? In this environment there are downside risks every day. Even if no economic data are due, there’s always the risk of some corporate announcement or downgrade by the rating agencies. But equities are renowned for climbing the Wall of Worry better than Gladiators.

For now I’m playing the long bet, but I’ll keep writing diary notes, reminding me to look for signs to open up a short position again, ready for the final big one!

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