We’ve been avoiding calling a bottom for months now. However, that could be about to change. Four of our five bottom indicators are turning bullish and we’re just waiting for one more.
Signs of a Market Bottom:The VIX sets new highs
The CBOE Volatility Index (“the VIX”) continues to set record highs. The VIX is a measure of the premium value placed on S&P 500 option contracts. It’s basically the cost of portfolio insurance. When fear is high, so are insurance costs.
The VIX set an all-time high of 89.53 on Friday. Previous market bottoms were set when the VIX went into the 40’s in 2003 and when it surged into the 50’s in 1998.
The VIX, at this level, is somewhat of a bullish sign. On its own, the VIX doesn’t mark the bottom of anything, but it is a good indicator to see that fear is reaching some extremes.
Signs of a Market Bottom: Weak Hands Walk Away
One of the surest signs of a market bottom is when the herd sells. The herd is the weak hands that chase hot stocks, pile in late, and always seems to hold on too long.
Trim Tabs Investment Research, which tracks the amount of money investors put into and pull out of mutual funds, reported last week an additional $6.47 billion was pulled out of mutual funds. According to Trim Tabs, “Outflows from equity mutual funds remain well on their way to setting all-time highs for October. August, September and October of 2008 are the three worst months on record for mutual fund outflows.”
The amount of fear i s getting downright ridiculous. A recent report from Canada ’s Globe and Mail states investors are even afraid to speculate with fake money:
Many business schools offer hands-on investing experience. It's a wild time to be getting feet wet in the stock market. "It's taught me that the markets aren't efficient after all," said Davies Town , 18, who runs the stock competition at UBC's Finance Club. He's had a difficult time persuading people to enter his contest: few want to touch markets now, even with virtual money.
The herd is moving away from stocks as fast as possible. The herd has an alarming tendency to buy and sell at the worst possible times; this is a very good sign.
Signs of a Market Bottom: Closed-End Fund Indicator
One of the least watched bottom indicators is actually one of the most important. It’s what I call the Closed-End Fund Indicator.
A closed-end fund trades like a stock and usually holds a group of securities that are tough for individual investors to buy. For instance, some closed-end funds hold distressed debt, municipal debt, or China’s “A” shares which only Chinese citizens are able to buy. They will also trade at a premium or discount to net asset value (NAV).
Two weeks ago, when the markets seemed like they just couldn’t get any worse, only 18 of the 597 closed-end funds were fetching a premium. That was the lowest number I have ever seen. The bearish sentiment in closed-end funds was peaking.
Now, 57 of the funds are trading at a premium. By historical standards, anywhere from 35% to 50% of them should be trading at a premium during a flat market. With only 9.5% of them trading at a premium to NAV, the markets are clearly overly bearish.
Signs of a Market Bottom:Perma-Bears Turn Bullish
There’s a small portion of investors who are always pessimistic. They are brilliant at finding reasons not to buy. They predict the end of bubbles long before they even start to form. They never get caught in bursting bubbles. But they also never enjoy the ride up. They’re called Perma-Bears.
Regardless of any good news, they always seem to be bearish. They rarely buy stocks. In many cases they’re the doom and gloomers who have been buying gold for 30 years waiting for their day. In other cases, they are investors that have the patience to wait 5, 10, or 15 years for their chance.
When leading perma-bears turn bullish, you know you’re nearing a bottom. And that happened a few weeks ago when Jeremy Grantham said, “You are looking at the best prices in 20 years, and you should be making 7% to 8% to 9% real (inflation-adjusted) returns. The last time I was this optimistic was in the summer of 1982.”
Grantham, who manages about $120 billion in assets for Grantham, Mayo, Van Otterloo, is one of the most prominent perma-bears in the world and has talked about how overvalued stocks are since the mid 90’s. After the latest market rout, Grantham is starting to turn bullish on stocks. That’s a very good sign.
Signs of a Market Bottom:Bad News Isn’t So Bad
This is the one we’ve been patiently waiting on.
The markets have been reacting to everything lately. As expected, the weaker job reports, news providing proof of a recession around the world, and almost every earnings report warning of weaker times ahead have steadily driven the markets lower.
Right now all that seems to matter each day is the economy. The Fed doesn’t matter, the bailouts are of little consequence, and talk of new stimulus packages (a.k.a. – checks for all) from Washington can’t get the markets turned around. That is all the market cares about right now and will continue to do so for the foreseeable future.
But here’s the key to spotting a bottom. When bad news comes out and the markets don’t go down, you can bet we’ve hit bottom. When news, isn’t as bad as expected, that means the market already priced too much bad news into a stock.
We haven’t seen much of this yet. But we will and then it’ll be safe to say we’ve hit bottom.
Four out of five isn’t bad, but it’s not great either. Plowing all your money into the markets now hoping to catch a bottom isn’t a prudent thing to do. After all, as most investors have learned, stocks go down a lot faster than they go up.
As we’ve said all along, there are three things you should be doing with your money right now.
First, have enough cash on hand to live for the next year or two.
Second, buy safe stocks cautiously. The high dividend stocks that will be able to survive a prolonged recession should hold up well.
Finally, this may be the buying opportunity of a life time. Don’t forget there is the possibility for the buying opportunity in five life times to come along soon.
This is the time when prudent investors lay the seeds for true wealth. Experienced investors know a turnaround will come and are saving up for it. Grantham has been preparing for this moment for more than a decade and we should take advantage of it right along with him by using a conservative investment strategy and picking our spots of when to buy.
Chief Investment Strategist, Q1 Publishing