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October 12, 2008

Bottom Fishing

Just after Paulson announced, in mid-September, that the U.S. government needed to spend $700 billion to save the banking system, stocks embarked on a 2-day, 10% rally. Once the news was fully digested, and people realized that the misdeeds of the last few years were, in fact, as dire as all the bears had been prognosticating, the bottom fell out. From the peak of the post-announcement rally to the depths of Friday morning's plunge, U.S. equity prices were discounted by one-third. Many folks were trying to call the bottom along the way, both the vacuous and the informed alike. SPX 1100 would be the bottom because of the spike in volume. Perhaps 1000 would be the bottom because it is a psychological level. Then 950 had to be the bottom because it was an important historical pivot point (this argument was my own).

Then something changed. We fell through 950 like someone trying to navigate quicksand with concrete boots, and real panic set in. Over the course of about 2 1/2 hours from late Thursday into Friday's opening, the SPX fell from 970 to 840, an 8.6% drop. Volume spiked. A quick 10% rally took hold and the airheads on TV did not hesitate in declaring a bottom. The world then sat shell-shocked as the morning spike slowly eroded over the next four hours. Despair was upon us, and the market was emanting a mood of impending disaster. We would end the week with another late-day rout... but we didn't. The second 10% rally of the day took hold and brought pre-weekend relief, at least to those who managed to get or stay long during the course of the day.

I reprise these events simply to illustrate how psychology played out during the crash of 2008 because I believe the crash is over. Friday's opening gap down constituted an exhaustion gap as far as I can discern. The low held during the tortuous mid-day selling, and the explosive rally at the end is a hint of things to come. Whether any rally turns out to be brief or extended, timewise, I believe it will be as fervent to the upside as the crash was to the down, if not more. Simply targeting the support level from which the crash accelerated suggests the SPX could rally to 1100 head-spinningly fast:

index chart

My portfolio saw it's first significant long positions in many, many months Friday based on some important tells. First, gold was cratering even as the SPX slid back toward the morning low. During the first four days of the week, I watched gold spike higher in opposition to my bearish read. The best explanation I could conceive was that the safe haven aspect of gold was in full force as the market crashed. To see the air come out of gold confirmed, in my mind, that the morning drop was an exhaustion.

Second, even while things were looking grim for the S&P 500, financial and technology shares were holding firm. It makes perfect sense for these sectors, especially financial, to lead the way out of the abyss. Finally, bond yields were beginning to spike ahead of the bottom. This development is a bit of a weaker tell, but a tell nonetheless, and one that will gain credence if a stock rally does, indeed, form and we see a continued rise in yields.

Now, to get a bit more speculative, here is my outlook for stocks going forward:

index chart

Although I do suspect that a bottom has been put in, I do not expect a V-shaped bottom. Why? Because I believe Wave 4 will last as much as 6 months and take the market up 30% or more. Such rallies do not typically form off V-bottoms, so expect another scare in the next 2-6 weeks that takes us below SPX 900 before rebounding sharply.

Without further ado, allow me to present some long ideas!

stock chart

Taiwan will be a huge benficiary of opened relations with mainland China. I took an initial position in EWT on Friday at $8.25 and will add to it on occasion. EWT also sports a 3% dividend.

 

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