Groping For A Market Bottom

Many have been calling for a market bottom.

A market bottom, according to Economist’s Market.view can be identified by the following signs (highlight mine):

``Bear-market bottoms usually require three things. First, they require the existence of forced sellers, to have driven prices down rapidly. Secondly, they offer some clear appeal on valuation grounds. Third, they need a catalyst, an event which, while gloomy, might conceivably mark the worst moment of the crisis.

That’s the way it has been in 2003, observes Market.view,

``All the requirements were in place in early 2003. Pension funds and insurance companies had become forced sellers of equities for solvency reasons. The dividend yield had risen sharply from its pitiful level during the dotcom boom; in the UK, it was higher than the yield on government bonds for the first time since the late 1950s. Finally, the onset of the Iraq war proved the catalyst, perhaps due to the sheer relief that all the uncertainty was out of the way. Equities duly rallied, sharply.”

Today, there are some signs of the reemergence the same pattern. According to Market.view,

``And there is a plausible case for saying all three elements are in place this time. Not, however, for equities but for investment-grade corporate debt. First, there have been forced sellers; notably hedge funds and specialist vehicles like conduits. Second, spreads over government bonds seem to offer a return that compensates for a very high level of defaults. Third, the collapse of Bear Stearns could conceivably mark the worst moment of the crisis.

And importantly, global fund managers who are overweight cash are at extreme levels, possibly indicative of a looming reversal, adds market.view (emphasis mine),

``Sentiment is also pretty gloomy at the moment, usually a bullish sign. According to Merrill Lynch’s monthly poll of fund managers, a net 42% of asset allocators are overweight cash, a record level. Since slightly more are underweight equities than bonds, that might suggest the stockmarket is a better bet. However, it is hard to argue that there have been forced sellers of equities; shares have held up rather better than corporate bonds. And equity valuations are only decent by historical standards, rather than compelling, even if one discounts the fact that profits are high relative to GDP.”

While it may possibly be true that the present levels of cash could serve as a contrarian indicator, the chart of global money managers who are overweight cash (in %), courtesy of the Economist and Merrill Lynch plus the S & P 500 weekly by bigcharts.com, appear to indicate otherwise-- that bear markets have, in the past, sucked out excess cash from global fund managers- from which the bottom has been marked by low levels of fund managers with available cash!

Since "Bear markets descend on a ladder of hope", maybe this attracts the phenomenon called the catching of "falling knives" or "bottom fishers" deplete their cash levels.

This also means that mere sentiment may not precisely reflect inflection points because general market trends can lead to protracted sentiment excesses. This noteworthy excerpt from Dr. John Hussman,

``Presently, the level of advisory bullishness is not much below where we would expect it to be, given the market decline that we've observed. That's often the case early in bull or bear markets. High bullishness in early bull markets is typically not a negative, because the initial advance is generally very powerful. Likewise, high bearishness is typically not a positive early in bear markets, because the initial decline is often fairly deep.” (emphasis mine)

Barry Ritholtz observes of “rampant bottom callers” or of many articles declaring to an end to the “bear” market or a market bottom.

These are likely to instead signify the “Denial stage” of the psychological cycle operating within the markets as shown above.

Besides, the present rally seems to be in reaction to the gamut of Central Bank measures; US Federal Reserves expanded TAF or the TSLF, the 75 bp cuts, reduced reserves of GSE to expand mortgage acquisition, Fed bypass of lending procedures the activation of depression era laws to “salvage” Bear Sterns and BoE and the ECB’s liquidity provision and more, aside, from the technical oversold conditions.

The notion is that all these measures will be sufficient panaceas to the present problem. We doubt so.

What’s more, today’s forced selling seems to be a function of liquidity induced problems borne out of some material insolvency within the financial industry. The peak of forced selling would most probably occur once the ‘critical mass’ of losses surface, which is not likely to be anytime soon.

Of course, valuations matter- that’s why we see some selective opportunities. But gains of the past will possibly not be repeated this year; you’d have to have a longer horizon aside from positioning defensively.

As for an event driven catalyst, this can possibly be seen only from the hindsight.

As a reminder, market trends or cycles are long drawn out processes and not simply one or two time events.