Is A Stock Market Bottom Near?

Recently, the Dow Jones Industrial Average (^DJI) and the SP500 Index (^GSPC) fell below critical levels. For the DJIA, that level was 7000 and for SP500 it was 700. In two of my articles from last year, I used P/E and GDP as possible valuation metrics and predicted that DOW would likely visit 5000 and SP500 would likely go below 600. So far that US market is heading in that direction.

At these levels, the media keeps on saying that investors are in fear and market is selling irrationally. I do admit that the short selling side right now is a little bit overcrowded. More and more people are betting against the market with the focus on the financial sector. Even at these levels, short sellers are not at all threatened by possible violent reversals. Perhaps this is why notable investors such as Robert Prechter from Elliot Wave International stated that he covered his short position on the SP500 and will just sit back and observe.  (link )

However, is there really enough fear in the market. Are people really panicking? Are we set for at least a short term sustained rally? I do not think that is the case and I would like to present some simple fear metrics to illustrate my point.

Below are the VIX (^VIX) and VXO (^VXO) values in comparison to the SP500 Index. VIX is a volatility index of the SP500 index and VXO is the volatility index of the SP100 index (^OEX).

(Data Source: Yahoo Finance)

As you can see, nothing in the volatility indices indicate an excessive amount of fear. Both volatility indices are only half of their October and November 2008 levels. What has been happening since the beginning of 2009 is simply steady and consistent selling.

This phenomenon is very different from panic selling because it shows that people are betting against the market or selling the market in a logical and calm fashion. This is indicative of a loss of confidence, emotional detachment from stocks or simply giving up on the stock market.

Going long in this environment is not only illogical but could be dangerous. Remember in order for the VIX and VXO indices to spike that much during October and November of last year, it took over 3000 points on the DJIA to achieve that or about 30% decline. I would not be surprised at all if we drop another 30% from the current level before we see a sustained rally and fundamentals to come back into the market.

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Comment by e-guy

2009-03-12 15:01:37

But, you think about this. Does it make sense to make predictions about future large drops when the only reason for drops is that the media are telling us that there will be drops?
As you must know it is all psychological not physical. People do not buy because they think more people will get laid off. But, that is the reason why people are getting laid off. If we all started talking and thinking positively, the whole affair would evaporate. So any prediction about the future on this recession has no weight except that it may be self-fulfilling.

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Comment by Tony

2009-03-12 16:12:07

Hi E-Guy,

I agree with you in terms of this crisis partly being psychological. However, this is not an emotional game. This is harsh reality. I would say back in 2007 and early 2008, alot of it is emotion. But right now, it is simply reality. If you don’t realize how severe things are and will become, then perhaps you will be caught by surprise. My recommendation is to study the root of the current financial crisis using sources other than the mainstream media.

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