Wednesday, March 4, 2009

How low can we go?

I don't mean to throw a wet towel onto today's China Syndrome rally, but I believe that this is only a temporary breather before the next leg down. Now I'm not the only bear in the forest—not by a long shot—and it seems as if I and my other furry brethren are struggling to answer the burning question of the moment: “Where do you think we'll find a bottom?” The best answer I can give to that is: Try a restroom.

Nobody knows anything right now
I don't mean to be flippant but I do think that the right answer is: Nobody really knows. The fundamentalists for sure don't know. Today on CNBC, one reporter (Bob Pisani?) said that analysts can't even come up with a reasonable guesstimate as to where earnings will be in 2009 which makes predicting any sort of support level impossible.

The technicians don't know, either. My charting program only carries ten years worth of price and volume data for the Dow Industrials and nineteen years for the S&P 500. The Dow has already broken through major support at the 7800 level and I don't have enough data to discern the next stop. The S&P recently blew through its 800 major support level as well as minor support at 755. According to its monthly chart, the next points of minor support are down around 670 and then 450.

Fibonacci levels
Technicians often resort to Fibonacci levels which are used in Elliot Wave Theory. Using the S&P 500 as an example with 1550 being the market top and 0 being the bottom, we get support levels around 960, 775, 590, and 365. The problem with Fibonacci levels is that they're not always accurate, and I especially have a problem using them over such a long time frame.

Aren't there any other places we can go to get some clues as to where a possible bottom might be?

How saving money will put us in the poor house
In his excellent column that appeared on MSN Money yesterday, Jon Markman used the Levy-Kalecki model of economic behavior to explain how high levels of saving and a decline in borrowing can lead to the devastation of corporate profits, a situation we could very well find ourselves in. Using this model, Markman came up with a couple of market scenarios--both rather grim tales. He said that if households save as little as 7% of their incomes, the S&P 500 could sink as low as 550 and the Dow as low as 5,300. If the wealthy are taxed per Obama's plan and savings rates go to 10%, the Levy-Kalecki model suggests that corporate profits will be slashed by 50% from their 2007 peak. Depending on whether investor confidence or fear prevails, the S&P could either end up around 755, a little higher than where it is today, or around 420, a lot lower.

I'm casting my vote for the fear camp and here's why.

The reason for another market downturn
The reason I think the market still has a ways to tumble is because of the VIX, the volatility index. The rule of thumb is that the more uncertain the market, the higher the volatility. Even though the volatility has been high lately, it's still nowhere near where it was last autumn. Below are daily charts of the S&P 500 and the VIX.

You can see that the VIX roughly inversely mirrors the movement of the S&P. When the S&P made new lows last October and November, the VIX made new highs (around 80). But the S&P has dropped well below those levels and what has the VIX done? It hasn't even come close to making any new highs. This divergence is a signal that the market has a lot more room to fall.

The answer to the question
So, where will we find the market bottom? The answer to this question is not where, but when. We'll find it when the VIX forms a new top, and it doesn't seem to be in a hurry to do that. So fasten your seatbelts 'cause it's going to be a bumpy ride!

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