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The Market Needs More Fear

S&P's Mark Arbeter says there has not been enough panic in the market for major indexes to trace out a strong bottom

From Standard & Poor's Equity ResearchThe stock market continues to get punished by ever soaring crude oil prices and the continued meltdown in the financial sector. One of these factors, in isolation, would be enough to send stocks lower, but both at the same time is simply too much to bear. (Pun intended.) As I looked at my quote machine early on Friday, July 11, crude oil was up $5.00 per barrel to a record high, Fannie Mae (FNM) and Freddie Mac (FRE) were each indicated lower by 45%, and foreign markets were very weak. Can it get any worse?

With all this bad news, U.S. stock futures were down only about 1%. However, that might be the problem. The water torture decline since the May high has been fairly consistent in slope. The problem is the slope has not been very steep, and therefore, we have not seen enough fear and panic in the market for a strong bottom to be traced out. One only has to look at prior market bottoms and their steep downward slope to get a sense of what is missing at this juncture. With most of the major indices below earlier year chart support, we think we might have to see another capitulation or two before seeing at least a temporary bottom to the bear market.

The S&P 500 sliced right through its March closing low of 1273 and the March intraday low of 1257 without even a bounce. This is somewhat surprising to us, but shows just how weak the market is. When markets don’t at least reverse a bit from key chart support, when they are markedly oversold, we think something is decidedly wrong. How much lower can the market go is anybody’s guess, but we will try to lay out some potential support areas that exist below current prices.

The next key chart support that we are focusing on comes from the pivot low in June 2006 of 1220 to 1224. Looking further back, there was also a pivot low in October 2005 in the 1170 zone. This 1170 area corresponds exactly with a 50% retracement of the entire bull market, which is the next key Fibonacci support level. We expect a counter trend rally to develop once the S&P 500 gets within 1170 and 1224, but in no way are we predicting that this area will represent the bottom of the bear market.

Below this potential range of support, there is a nice layer of chart congestion that lies between 1063 and 1150. This is from the sideways action from back in 2004. A 61.8% retracement of the bull market targets the 1078 level, right in this second zone of chart support.

The price structure of many indices appears to be taking the shape of a 5-wave decline and that is very typical bear market action. Within the 5-waves, there are three waves down and two counter trend or corrective waves up. Wave 2 cannot retrace all of wave 1, while wave 4 can not move above the bottom of wave 1, otherwise the wave counts are invalid.

The first wave down to the closing low on November 26 took 33 trading days and encompassed 158 points and represented a 10% decline. The second decline or third wave of the pattern took the S&P 500 down 243 points or 16%. If wave 5 is similar in size to wave 3, we could arrive at a target of 1198 as a potential low for the bear market and this corresponds to the first range we talked about above.

So where’s the desperation, the panic, the capitulation? Well for one thing, it’s not showing up in the options market. Put/call (p/c) ratios are nowhere near the panic levels that we saw in March and January or even back during the pullbacks in 2007. The recent high for the 10-day CBOE total put/call ratio was 1.1 on July 7, high historically, but not relative to recent peaks. In March, the 10-day hit 1.28, in January, it reached 1.2, in August, 2007, it spiked to 1.29 and in March, 2007, it shot up to 1.31.

We can see the same pattern from the 30-day CBOE p/c ratio. The recent high was 1.04 compared to the 1.17 to 1.18 levels seen in March and August, 2007, and in March, 2008. When we examine the equity-only p/c ratios, they are showing relatively more fear than the total p/c’s but still not at levels seen in March. The 10-day equity-only hit 0.82 on Thursday, July 10, way below the 1.00 level in March and slightly below the levels in January, 2008, and August, 2007. If we look at the ISEE Sentiment Index, which is a call/put ratio, we see a lack of fear relative to what we witnessed in March. We have seen some fairly low readings from the ISEE index but not like the extremes we had in March. The 21-day exponential average of this index has been flat of late, and is currently sitting at 112, way above the panic lows of 83 near the March market bottom.

The VIX, or market volatility index based on the options traded on the S&P 500, spiked on Friday to 29%, its highest level since March 20, and we think a welcome sign for many market pundits. Volatility indexes are a function of option premiums and basically rise, sometimes rapidly, when the market heads south. But, just because the stock market is moving lower, does not mean that we will have to see a spike in the volatility indexes. This is something that we think many on the Street miss. In our view, volatility indexes, because they are a function of option premiums, will move rapidly higher when the price of the stock market heads rapidly lower.

When prices are falling rapidly, investors will pay up for protection, pushing option premiums higher. The decline since May has been somewhat gradual in slope, and we think this is why the VIX and p/c ratios have not spiked like they did in January and March. If and when the market accelerates to the downside, and the slope of the decline becomes very steep, only then will we see a spike in the volatility indexes.

For instance, both the 3-day and 10-day rate-of-change (ROC) for the S&P 500 was greater in January than it was in March, and greater in March than it was in July. The VIX recently hit its high in January, followed by a lower high in March and lower high currently. The same thing happened during the bear market in 2002 and 2003. The price ROC during the July, 2002, bottom for the “500” was greater than the ROC in October, 2002, and that was higher than the ROC in March, 2003. The VIX peaked in July, 2002, hit a secondary high in October, 2002 and in March, 2003, and came nowhere near the July or October levels.

The second part of this discussion has to do with how far the VIX moves during an intermediate-term decline in the market. In December, 2007, the VIX bottomed at 18 and spiked to 38 in January. However, in February, the VIX bottomed just above 21 and moved to 35 in March. In May the VIX bottomed at 16 so it has had further to travel than it did in January or March.

While we are not seeing fear from the options market, we are seeing a healthy dose of alarm when it comes to some of the sentiment polls. In the latest Investor’s Intelligence poll, bulls declined to only 27.4% and bears rose to 47.3%. This is the lowest level of bullish sentiment since July, 1994, when they bottomed at 23.3% and the highest level of bearish sentiment since September, 1998. Bearish sentiment is greater than bullish sentiment by 19.9 percentage points, the most bearish reading by newsletter writers since December, 1994. The Consensus poll hit 23% bulls, almost equaling the 22% we saw in March, and an extremely low figure. The American Association of Individual Investor poll is showing 22% bulls and 55% bears, also very close to what we saw in March.

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