28 March 2008

Is the Bear Sleeping? Or Is He Festering Carrion?

I recently read a Business Week piece on whether or not the market rebound earlier this week was a sucker's rally? Is the bear taking a quick snooze, or is he decomposing carrion?

My read on the market is Growler nodded off a bit after a rampaging start to the year. A bear needs some time to digest some of the ample offerings this season, like the cannibalistic devouring of Bear Stearns.

Here are some excerpts from Business Week:

The stock market is like a sprinter, says Chris Johnson of Johnson Research Group: It runs in one direction and eventually needs a break. "There's only so far a market can go before it gets oversold," Johnson says.

In other words, even a rampaging bear needs a breather now and then. In a bear market rally, despite weeks of losses, a bleak economy, and a raging credit crisis, stocks will bounce back. Temporarily.

To distinguish a bear market rally from a true market bottom, investors often look for extreme levels of pessimism. When investors get extremely pessimistic, they've reached the end of their selling, the theory says, and that's a great time to buy stocks.


Johnson says the market bottom is more likely to be a "process" than one single event. He's carefully watching the VIX index, a measure of volatility in the market that is traded on the Chicago Board Options Exchange. The VIX was above 25 on Mar. 25, and, through the worst of the recent crisis, the VIX has traded up to about 35. When this measure of fear hits 40, Johnson says, pessimism might finally have hit extreme, and bullish, levels.

If you look at a recent chart of a bullish market, you'll see that the market occasionally pauses, and pulls back to its 50-day moving average, before continuing along its longer-term trend. The chart below shows the Dow from October 2006 through June 2007--a bull market with a series of small pull-backs, or bull naps, along with a more substantial rest for the bull in March 2007.

The current bear market has had its share of bear naps, as the arrows on the chart below helpfully point out.

Eventually, the bear will one day go to sleep, and fail to wake up. No kids, he's won't be dead, just hibernating.

Chris Johnson in the Business Week piece kinda sorta hedgingly believes that the bear will shuffle off this mortal coil when the VIX hits 40. I get the feeling that he pulled that nice round number out of his posterior, but it can't hurt to keep track of the VIX and look for extremes in sentiment.

Here's a weekly chart of the VIX. Notice that volatility has been quite elevated recently. Also notice we are nowhere near a VIX reading of 40 right now.

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