Emotions will take prices to irrational extremes
Prices always revert back to the mean
Over the years, I have discovered that irrational extremes are quantifiable on a pretty consistent basis. If you can identify likely extremes to which prices normally go in times of extreme emotion, you can put yourself in a position to be making decisions at high probability turning points. This can prove to be very valuable.
I want to define a couple of things before I get into detailed analysis of where we are in relation to what has occurred in the past.
The Mean in statistical terms, is the average of a set of numbers. For the markets, I use the average value for the last 30 weeks. If you plot this average every week on the chart, you get what is called the 30-week moving average (Green Line).
Over time, price moves back to the 30-week moving average, or “reverts” back to the mean.
You can quantify the emotional over-reactions as price moves a specific percentage away from the 30-week moving average. Historically, in a panic, prices move 15% or even 20% below the 30-week average. That range of 15-20% below the 30-week average tends to be a very good place from which to look for reversals up in stock price.
If you haven’t yet figured it out, I love managing money. I love the combination of mathematics, emotions and psychology. Knowledge gives me an edge and an intense work ethic allows me to build up an extensive knowledge of historical price movement. Moreover, it is of paramount importance to know how to protect assets when risk increases and opportunity diminishes.
Again, I made it real clear in early 2008 that we were now in a Bear Market for stock markets. I went on defense. My gameplan shifted from buying dips to shorting rallies. It has proven to be very successful this year.
Using the last 12 year of market activity, I figured that I would get chances to buy stocks on extreme moves down in price. I even sent the following chart to clients on several occasions to give them insight into how I was making decisions.
In 1998, the markets were in turmoil as the Long Term Capital hedge fund got over-leveraged and collapsed. This caused a meltdown in the derivative markets and the markets crashed. This panic only took the S&P 500 15% below (Blue Line) its mean (Yellow Arrow).
The Bear Market from 2000-2003 saw the markets fall to 20% below the mean on several occasions (Black Arrows). The markets did not have a weekly close below the Red Line, so any selloff below those levels was immediately rewarded if bought.
In early 2008 (Green Arrow), the markets again were stretched to the Blue Line. At the time I had to analyze the markets and determine if we were replaying 1998, and would rally to new highs, or replaying something similar to 2000-2003 and would find the markets at much lower prices over the next year or two. I thought we were replaying the 2000-2003 market and chose to short the early 2008 rally. History has proven me to be right.
I have expressed a lot of frustration during this Bear Market of not being able to buy extreme moves in price. This is because we have not yet seen the markets get to the Blue Line. Every time the markets get close to cracking, the Fed steps in with some new intervention scheme and the markets bounce a little and I am unable to get a decent risk reward to buy any bounce.
Rallies from this extreme condition have proven to be very profitable. During the 2000-2003 Bear Market, there were four such rallies (Black Arrows) -
Low Date High Date Low Price High Price Return
3/19/2002 5/21/2001 1081 1315 21.6%
9/17/2001 12/03/2001 944 1173 24.3%
7/22/2002 8/19/2002 775 965 24.5%
10/07/2002 12/02/2002 768 954 24.2%
The returns are uniform, because the market tends to rally from 20% below Mean, and then rallies to a few percentage points above the Mean before topping and starting another leg down.
I took a look at the daily charts of each of these legs down and what I noticed was that the trends accelerated down into the lows as panic selling took hold and people sold out at any price.
Final Selloff Numbers (all daily measures are trading days, not calendar days)
Start Price Bottom Duration Loss
1. 1260 1080 10 Days -14.3%
2. 1130 944 8 Days -16.4%
3. 990 775 12 Days -21.7%
4. 850 770 7 Days -9.4%
Amazingly enough, the top of this current leg down is 1265.12 and Monday will be Day 10 of the crash. That is 5 points from the top of the first crash in 2001. I would not be surprised to see the price decline stop between 1080 and 1040 in the next few days.
Sentiment, Momentum and Market Internals
When I start to hear guys like Jim Cramer who have been wrong the whole way down tell me how to play the next 3,000 point drop, I recognize that sentiment may have changed and I may get a chance to buy an extreme selloff in stocks for a bounce that very few are expecting.
Here is a chart of the S&P 500 with several indicators to show just how extreme the current price move is when compared to normal market conditions –
The Top Box is the price of the S&P 500
The Second Box shows the Bullish Percent Indicator ($BPSPX). This indicator measures the percent of stock which are in uptrends. A reading at or below 20 has been seen on 5 occasions in the past 11 years. It has proven to be a good to buy stocks.
The Third Box shows momentum (RSI (14)). Think of momentum as the strength of the trend. A reading below 30 indicates that there is incredibly strong selling - think panic. This low reading has occurred 5 times in 11 years.
The Fourth Box measures volatility in options contracts ($VIX). Think of this as the price of insurance on stocks. The higher the reading, the more people are willing to pay to insure their stock portfolios. So an extremely high reading indicates panic by market participants. An extreme reading of over 40 has occurred only 5 times in 11 years.
So all the things I look for at a tradable bottom in a Bear Market are lining up. I am seeing panic, broad-based selling. I am seeing panic activity in the options market and the perma-bulls have thrown in the towel.
I will come out with a list of potential set ups in the next few days. For the first time in 10 months, I want in.
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