Arguments for Equity Short Term Bottom

I made an argument that the S&P500 may have reached the bottom in previous post (7/13) by using speculator's net S&P500 index futures and options as a proxy. The speculators have build up their long positions for last three weeks and most importantly that the net long positions increased incrementally from closing short position and increasing long positions. There are two other market sentiment indices also point to the possible S&P500 bottom in the near term.

The first measure is the ratio of numbers of stock reaching 52 week high to 52 week low for the total US markets (52HL ratio, thereafter) calculated from Bloomberg database (the data is available beginning on 10/25/02). Using the last 5+ years data, the 52HL ratio is a very good contrarian market indicator (See chart below). For all the market corrections we have experienced during the study period, the 52HL ratio exhibited as an almost perfect turnaround indicator. Whenever the ratio reading was close to 0.1, i.e., stock 52 week low numbers is 10 times greater than the 52 high, the S&P 500 index reached the bottom (see the chart "S&P500 and Ratio of 52wk high to 52wk low", the red line represents S&P500 index, the shaded column is the 52HL ratio).

The critical level of 0.1 worked perfectly for all the market corrections occurred in 5/2004, 8/2004, 10/2005, 6/2006 and 8/2007. From the chart we can see that entering 2008, the 52HL ratio readings indicate two characteristics: 1.) Very negative breath, throughout 2008, the numbers of stock with 52wk high almost were always lower than than 52 week low, represented by ratio less than 1 (represented by area below the horizontal axis=1); 2.) The 52HL ratio reached all-time lows, less than 0.05, in three occasions (Jan, March and July) this year. As matter of fact, there were only 44 stocks hitting 52 week high on both 7/3 and 7/7, a level we had not seen for the study period (10/25/2002 - 7/16/08), and the corresponding 52HL ratio were 0.03 and 0.04 respectively. The lowest of reading on 52HL ratio was 0.02, only occurred once on 1/22/08 and the next lowest was 0.03. Even mathematically it is possible for the 52HL ratio going lower, it won't be surprised that the worst case scenarios may already be priced in the markets, and the extreme negative sentiment on July 4th weekend may become a turning point.

The second market sentiment measure, AAII (American Association Individual Investors) weekly bullish and bearish statistics. AAII % bulls or bears had not proved to be reliable indicators for the short-term market direction. But the extreme readings, especially the % bulls provided some valid indication for market momentum shift. Using the data from last 10 years, % bull readings dropped below 23 only four different period times, 98 emerging market currency crisis, spring 2003 the bottom of tech bubble bear market and spring 2005 unwinding JPY carry-trade, and current subprime crisis (see the chart below, black line represent S&P500 historical price, green line is % bulls and red line is %bears). In all three previous occasions (marked by blue circles), the reading below 23 for %bulls pointed to the bottom of the equity markets (represented by S&P 500). Is this time going to be different from previous three? It is possible, but "history may not repeat itself, but it does rhyme" (Mark Twain). I do love the risk-reward for the current market if you are not in the market for a quick buck or two.

Lastly, when you examine the massive negative media hoopla on the current market distress, you have to wonder its impacts on the psyche of investors and hence the aggregate markets. The chart below was generated by using Google Trend, it shows the Internet traffic of "bear market". The search traffic and news coverage hit the all time high at the July 4th weekend. It is general consensus that economy probably won't accelerate this quarter, but the key question probably should be how bad the economy has been priced in the equity markets. Comparing to alternative asset classes, especially bond market, equity looks like a bargain for me.