Back in the day, late night host Johnny Carson used to do a bit called “Karnak the Magnificent.” He would don a large mind readers hat, place a sealed envelope to his forehead and deduce the “answer” to the question inside of the envelope. He would then open the envelope and read the question – invariably revealing the “answer” to be of the funny, smart aleck type.
So in my best Karnak impersonation – but without being funny at all – this week’s title is the answer to the question in the envelope. The question in the envelope is simply “What’s the most painful time for investors?” Yes, that’s right, “getting to oversold.” Because in order to get to an oversold condition the market must first – yes, you guessed it – sell off. And unless you are in cash, net short or a dangerously eternal optimist, this is a painful process, because it almost invariably involves losing money – at least for awhile. Plus, despite the claims by hordes of modern day Karnaks’ (also known as “professional market analysts”) no one ever really knows how big any given decline will get before it finally bottoms out.
So here we stand today. As you can see in Figure 1, all of the major market averages have plunged since topping out in May. So what happens next? And how soon?
Figure 1 – The Major Averages sell off
click to enlarge
The Typical Process
Each time the market tops out and heads lower, as the decline starts to grow it typically becomes just one more incarnation of the immortal (albeit unconfirmed) first words of Adam to Eve, “stand back, I don’t know how big this thing gets.” Below are the “typical” steps followed by the “average” investor:
Step 1. Frantically scour the internet and cable TV seeking “expert” opinions.
Step 2a. If (as is usually the case) this intense search results in 10 different experts espousing 10 different outlooks, the “typical” response for the “average” investor is to thrust one’s hands into the air and vent frustration, typically using words that I am hesitant to put into print here, unemployment levels being what they are.
Step 2b. Here’s where it gets tricky. For better or for worse most “average” investors ultimately develop a certain comfort level with Step 2a. By relying on “experts” one can if one so chooses mentally disavow any responsibility for actually taking charge of one’s own financial situation. So if the experts all disagree then this provides a built in excuse average investor to waffle and vacillate. However, where it really get’s interesting is when the market is declining and the experts all agree that further declines are ahead.
In this case, the “typical” response from the “average” investor is something along the lines of “Oh my God, its financial Armageddon, I am going to lose all my money and end up living in the street!” (Note to the average investor: Hey, way to keep it together). In reality – and ain’t human nature a kick in the teeth – if all of the “experts” agree that the market is headed lower (trick answer alert) in most cases, it is time to at least start thinking about buying. Unfortunately, here too the average investor tends to over react, diving in headlong, rather than waiting for some sign of a bottom and reversal.
So in a nutshell, by the end of Step 2 the vast majority of investors are busy either, a) quickly shoving his or her respective head back into the sand, or, b) diving headlong into the market (i.e., attempting to “catch a falling safe”).
Step 3a. If the 10 experts give 10 differing opinions then more than ever it is time for the average investor to go back to where he or she should have been all along – ignoring the experts and following a previously devised and well thought out trading plan – one that addresses such mundane issues as capital allocation, risk controls, entry and exit triggers and so on and so forth.
What is interesting here is that so many investors will read that last line and say “why yes of course, that makes great sense.” Still they never quite get around to doing it. Which explains a lot, don’t you think?
Step 3b. If the experts all agree that the sky is indeed falling – thus setting the stage for the next advance – it is nevertheless recommended that you wait for some sign of a reversal before jumping in. Yes, attempting to “catch a falling safe” can surely be counted on to provide an intense, yet ultimately brief rush of adrenaline. And if you actually pull it off, it’s a pretty cool trick – or at least I suppose it is, since come to think of it, I have never actually seen the trick performed successfully. This implies that in the vast majority of cases, the results “ain’t pretty.”
So “the question” is “with the market down so much in recent weeks, is the market oversold?” Let me answer that simple question with another question. “Does the weather suck!?” (anyone in the contiguous 48 states pretty much knows the answer to that one). With the market down six weeks in a row and a new “low for the move” low registered a day ago, we are definitely getting into oversold territory. Of course, that’s fairly obvious. The real question on investor’s minds is “are we there (at the bottom) yet?”
The Answers – Part I
To answer this question I will display two overbought/ oversold oscillators that I developed and follow. Now when I say “I developed” them what that really means is that I took a bunch of indicators that other people developed and threw them together to see what it looks like. And also, while I say that “I developed” them in order to try to impress you with my “professional analytical skills” the truth is that these oscillators look a whole heck of a lot like every other oscillator, i.e., when the market rises the oscillator values rise and when the market falls the oscillator value falls. Cutting edge stuff, eh?
Nevertheless, Figure 2 displays an oscillator (my Stock/Group/Sector Oscillator) that focuses on the overbought/oversold nature of a large group of individual stocks, industry groups and sectors. As you can see, the oscillator itself is a little “busy”, meaning it fluctuates fairly rapidly. But the key thing to note (at the far right hand side of the chart) is that it is presently “low” at just 6.2 (on a scale of 0 to 100).
Figure 2 – Jay’s Stock/Group/Sector Oscillator in Oversold Territory
click to enlarge
Following readings in the lowest decile – i.e., the lowest 10% of all readings (all daily reading between 0 and 11.4):
-The average subsequent 21-day gain is +1.86% (versus +0.26% for all days)
-The average subsequent 63-day gain is +3.55% (versus +0.85% for all days)
-The average subsequent 126-day gain is +6.36% (versus +2.07% for all days)
-The average subsequent 252-day gain is +12.28% (versus +4.61% for all days)
The Answers – Part 2
The oscillator displayed in Figure 3 (my Kitchen Oscillator) combines a number of standard overbought/ oversold type indicators, including:
-the put/call ratio
-the VIX index
-Advances/Advances + Declines
-the McClellan Oscillator
Figure 3 – Jay’s Kitchen Sink Oscillator
click to enlarge
As you can see, the oscillator in Figure 3 is a little less volatile than the one in Figure 2. As you can also see (at the far right had side of the chart) it is presently in negative (i.e., oversold) territory. However, as you can also see it is not at “wildly oversold” levels. So there could still be more on the downside.
So what does it all mean? Do the presently oversold readings from both of my oscillators suggest that the next major rally in stock price is just around the corner? As a matter of fact, if history is a reasonable guide then the answer is “yes, probably.” A few questions still remain however. While these (and virtually any) market oscillators can tell you when the market has reached an oversold level, they typically do not tell you:
- How much further (or longer) until the actual bottom is in
- When the actual bottom is past and “smooth sailing” is nigh
So for now the key piece of information to glean from all of this is to respect the market and use caution in case the market action at the bottom gets nasty. But the good news is that we may be closer to the bottom than to the top.
So in the immortal words of Kevin McAllister in Home Alone, “Don’t get scared now.”
Jay Kaeppel – Optionetics