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March 06, 2009

SPX Bottoms
by Adam Hamilton

With the S&P 500 slumping below its November panic low, it's been one tough week in the stock markets. The SPX was holding its own until the Marxist Party inexplicably decided to announce giant and aggressive tax hikes on American investors. So confidence, already very weak after the first true stock panic in 101 years, continued flagging on the Marxists' plans to steal ever more of the fruits of our labors.

On Monday in particular, when the SPX plunged 4.7% to close just over 700 (6.9% under its panic low), the sense of despair was palpable. Everything looked bearish, everyone was pessimistic, and all hope seemed lost. It felt like all the cards were stacked against American investors, and the withering attack on our hard-earned capital by the thieves in Washington was the straw that broke the camel's back.

Monday's slide to 700 wasn't extreme enough to look like a classic capitulation (like November 19th and 20th's sharp 12.4% plunge did), but it sure felt like there was an overwhelming sense of resignation. If nothing is going to improve for a long time, why not just accept this misery as the new norm? While I felt awful too, I also felt an eerie sense of déjà vu. The total surrender reminded me of events 6 years earlier.

In early March 2003, the stock markets as represented by the SPX looked horrible. This flagship index had fallen 49.1% between March 2000 and October 2002. After closing at 798 in July 2002 capping a brutal 31.8% slide in just 4 months, the SPX couldn't gain any traction. It ground listlessly sideways to lower, looking increasingly sickly. By early March 2003, it was back down near 801 again.

For nearly 8 months the SPX had flatlined and done absolutely nothing. Hope seemed lost in March 2003 too. The Imperialists in Washington were massing an invasion force to annex Iraq. The threat of a long and bloody foreign war, the very type of entanglement our founding fathers warned against, hung over the economy and markets like a pall of choking smoke. The upcoming war was a monumental uncertainty.

Go back and read articles from world-class newspapers on the Iraq war published in January and February 2003. The fears prior to the event were staggering. Would Iraq torch its oilfields like it had done to Kuwait in 1991? Would Saddam Hussein wipe out Riyadh or its massive oilfields with Scud missile strikes? That would have driven oil prices stratospheric, which probably would have sparked a global depression.

Would Hussein rain fire on Israeli cities, goading Jerusalem into striking back? This could have ignited a giant Islamic jihad against Israel and the Western world. Were Iraqi sleeper cells lurking in US cities, ready to retaliate for a US invasion with Russian suitcase nukes? If these terrorists didn't have NBC weapons, would they go into shopping malls with AK-47s and slaughter thousands of Americans across this nation?

Ahead of this war in early 2003, everything looked bearish, everyone was pessimistic, and all hope seemed lost. Of course we look back on this today and laugh, as the Hussein regime thankfully proved to be a paper tiger. But the threat of war waged on American streets by Iraqi factions or Islamic sympathizers, the threat of economic and ecological catastrophe if Persian Gulf oilfields were blasted offline for years, make today's tight credit environment look like a sentimental picnic.

Yet as is nearly always the case in times of extreme pessimism, the worst case didn't come to pass. The oil kept flowing, the fabled sleeper cells never emerged to wreak havoc in America, and life and markets marched on as always. While exceedingly hard, the very times when things looked the bleakest in late 2002 and early 2003 were the ideal times to buy stocks to ride the coming 101.5% SPX bull market.

Sentiment today feels so much like it did 6 years ago, resigned despair. I can't help but marvel at the psychological similarities. So I've also been wondering how today's SPX stacks up against the famous late 2002 and early 2003 SPX bottoming period technically. This week I decided to build some comparison charts and take a look. The parallels are quite amazing and very illuminating on today's future prospects.

This first chart superimposes today's SPX since June on top of this same index from June 2002 to March 2003. Today's SPX is rendered in blue while the SPX of 6 years past is shown in red. While market history never repeats itself exactly, it often rhymes. And there is no doubt technically that what we've witnessed since October (after the primary panic plunge) mirrors the last major SPX bottom pretty well.

In that awful period 6 years ago, the SPX ground sideways to lower for many months. It not only gradually hit lower lows as this painful bottoming process continued, but even its occasional highs carved downward-sloping resistance. After stocks being cut in half and then staying near lows for the better part of 8 months, investors really had little reason to be optimistic or deploy capital 6 years ago today. It was a very dark time.

Any of this sound familiar? Today we've seen the SPX grind sideways to lower for many months. It has hit lower lows, the latest of which emerged this week. Even its highs have been lower, as the blue resistance line above shows. You can't look at any chart of US stock-market action since October and see anything other than incredibly bearish technicals if you are honest. There is no other interpretation.

While 2008's extreme panic selloff was far steeper and faster than 2002's selloff, once the SPX got to its initial lows in October it behaved similarly even though its means of arrival were different. Note above how closely the SPX of December, January, and early February tracks that of these same months 6 years ago. In both Decembers, the SPX appeared to stabilize near its bottoming-range highs with a sizable rally leading into year-end. Even the absolute SPX levels were nearly identical, these charts are interchangeable.

In both Januaries, an initial rally soon fizzled out which led to a sharp selloff that dragged the SPX back towards panic lows. In both Februaries, the SPX ground lower initially in a sickening bottom-feeding fashion. Enthusiasm was nowhere to be found. Things decoupled a bit in late February though. Back in February 2003, the Marxists weren't running Washington and self-righteously telling already overtaxed American investors that we aren't paying enough taxes.

The overall sense of symmetry between 6 years ago and today is undeniably strong. The fact that the SPX was trading in almost the same range as today is even more compelling. Late 2002 and early 2003 was absolutely a classic SPX bottoming period and today's SPX action mirrors these bottoming patterns of behavior very well. Today's shell-shocked investors would do well to ponder this corollary.

Bottoming is a nasty business. It never feels good, and it is never obvious at the time that a major bottom that will last for years to come is being formed. Stock-market action drives newsflow, and since the SPX does so poorly newsflow is overwhelmingly and hopelessly bearish. Bottoms feel terrible. You are not excited about a potential bull, but sick to your stomach about the sheer hopelessness of the situation.

While it is mostly horrendously low stock prices that drive this despair, extreme volatility plays a major supporting role. While speculators love volatility and can thrive in such times, investors hate it. To wake up some morning and see 5% to 10% of your total stock wealth evaporate within hours tests the mettle of even the most battle-hardened investors. Sustained extreme volatility only happens in bottoming periods.

This next chart examines the same June-to-March spans separated by 6 years, but from the perspective of volatility. Back then, the critical S&P 100 implied volatility index was called the VIX. The S&P 100 is the top 20% of the S&P 500, the biggest, best, and most-liquid companies in America. During times of extreme financial stress, it is the stocks of these elite S&P 100 companies that traders rush to liquidate since there is always a ready market for their shares with minimal risk of self-driven adverse price impacts.

In other words, if you need to sell fast to raise cash, the quickest and safest place to do it is in the stocks of the biggest and most-widely-traded companies you own. Their volume can absorb your own selling without it damaging the price you get, which can happen in small and illiquid stocks. So the S&P 100 stocks are where the majority of the trading action is during times of extreme fear that mark major multi-year bottoms.

Unfortunately in September 2003 the classic S&P 100 VIX was suddenly changed into today's S&P 500 VIX with an entirely new calculation methodology. Today the classic S&P 100 VIX that traders watched 6 years ago is known as the VXO. So even though I charted the VIX 6 years ago along with the VXO today, they are the same S&P 100 implied volatility index. Today's VIX is not comparable with the original VIX.

Once again today's VXO is rendered in blue. But since we saw an ultra-rare stock panic in 2008, volatility (and hence fear) then was far higher than 2002. In order to make these 2 data series more comparable visually so we can see volatility's behavior on a common scale, I multiplied the VIX from 6 years ago by a factor of 1.73x. This takes its 2002 high up to the same levels we saw in 2008's panic for easy visual comparison. This inflated VIX is rendered in red, but the actual raw VIX from 2002 is still shown in yellow.

We saw a triple VIX peak 6 years ago, spread out across a few months. This means there were 3 episodes during that SPX bottoming of incredibly intense fear and abnormal selling pressure in the US stock markets. And yet again we see a strong echo of this bottoming behavior in 2008. Today's VXO carved a triple peak too, 3 separate intense selling episodes spread out over a couple-month span.

Even though today's triple fear peak occurred at much higher levels than 2002's due to the extremeness of the stock panic, the reappearance of the triple-peak bottoming fear signature and its aftermath is very provocative. The 2002 bottoming episode showed that fear peaks relatively early in the bottoming, with several distinct fear climaxes. But even though stocks continue grinding sideways to lower after that, fear doesn't again approach the crazy levels it saw in its initial triple peaks.

We're seeing the same phenomenon today. Fear peaked during the stock panic in October and November. Since then, even to this week as the stock markets have plumbed very discouraging new lows, fear has been moderating on balance. When the SPX initially falls to a depressed level, its psychological impact is devastating. But after months of trading at these low levels, traders gradually start to accept them as the new norm so anxiety fades.

It's also interesting that both Januaries saw a sharp VIX/VXO surge. Fear increased on renewed stock selling in the new year, yet in both cases the raw levels of fear signaled by implied volatility were far lower than at the triple-fear climaxes months earlier. This brings us to an interesting debate about the necessary duration of the SPX bottoming process psychologically versus any seasonal component to it.

Although very few investors today are even considering these provocative 2002/2008 parallels, many of the ones who are rightfully point out that today's bottoming process remains younger. The SPX first fell under 800 in July 2002, the initial low of its bottoming process. But in 2008, the SPX didn't fall under 800 until November, and its initial low was actually in October. So today's bottoming is 3 or 4 months shorter than 2002's depending on how you want to define it.

Therefore, instead of seeing the bottoming end in March like in 2003 it might be pushed out 3 or 4 months farther. I have no problem with this argument and agree it is logical. Perhaps it really takes 8 months of horrible markets for enough weak hands to be washed out for decisive selling exhaustion to finally arrive. It's only after all the traders scared into selling near the bottoming lows have sold that the subsequent rally can launch.

But just maybe seasonality is a factor too. Even though this pair of bottoming processes' beginnings were offset by a few months, their Decembers, Januaries, and early Februaries looked very similar in both technical SPX terms and in volatility-signature terms. Both events saw new lows in October, which is of course the month in market history that has seen the most serious stock-market plunges. Seasonality, the effect of the passage of the calendar year on investors' collective psyche, can't be overlooked.

I've pondered and studied seasonality in various markets quite a bit over the years. It really exists, although often just as a secondary driver. Here in the Northern Hemisphere, people tend to get more depressed heading into the dark days of winter and more hopeful when the sunlight starts returning again in the spring. It's just hard to be pessimistic when spring is emerging. So while I wouldn't fall on my sword on this, it would not surprise me one bit to see today's SPX bottoming process end again this month.

Also on duration versus seasonality, the 2008 panic was radically more intense than the selloff that ended the last stock bear in 2002. With much more selling done in a shorter period of time, driving far higher fear, perhaps the necessary psychological damage to drive a major multi-year bottom has been accomplished more quickly this time around. If so, 2002's duration may not transfer as cleanly to today as some expect.

This last chart shows what happened after that ugly 2002 bottoming process. Once the invasion of Iraq that was generating such enormous popular anxiety actually happened, investors soon realized the worst-case scenarios wouldn't play out. They never do. So the SPX started surging in mid-March, up 26.3% by mid-June and 44.6% by the following February. It pays big to buy stocks when everyone else is too scared to do so.

While the rally out of today's SPX bottoming will be unique, the angular blue line here traces 2003's rally to give a rough idea of what we might expect. There was a sharp rebound soon followed by a steep initial rally. This uptrend moderated in the usual summer doldrums, but the SPX's ascent continued. 2003 ended up being one of the SPX's best years ever right after 2002 was one of its worst ever.

I don't know what the catalyst will be this time around to mark the absolute end of today's bottoming process. Whatever it is, I'm sure it won't be as clean as the Iraq invasion. But that doesn't matter. At some point, all the weak hands are out and selling exhaustion arrives. When all the frightened investors scared into selling at exactly the wrong time have sold, there will be no one left but buyers and the SPX will rally. This is as inevitable as spring following winter.

Many times when writing these essays, I am thankful to be able to tell you about good calls on the markets I made in the past that netted big profits for our subscribers and ourselves here at Zeal. So I would be remiss not to tell you exactly what I thought 6 years ago this week. I had made big money shorting the SPX in 2001 and 2002. Its technicals still looked overwhelmingly bearish in early March 2003 and the VIX's sharp rise in January that year made it look like still one more downleg was coming.

So 6 years ago this week, I was heavily short right on the cusp of the end of that bottoming period. I even wrote an essay on it called "S&P 500 Waterfall Imminent". It was the single worst macro call I've ever made in my entire career as a speculator. The SPX soon soared and I suffered the biggest losses relative to my trading capital at the time that I've ever taken. It was a hard, hard lesson about bottoming processes that I will never forget.

Stock markets bottom when things feel utterly hopeless, when stocks and the underlying economy look like they won't start recovering for years yet. Stock markets bottom when technicals look horrendous and every trading indicator you can find is loudly calling for new lows extending into the foreseeable future. Stock markets bottom when shorting feels like a sure thing and the mere idea of going long the stock markets makes you feel physically ill. Stock markets bottom when almost no one expects it. Bulls are born in despair.

At Zeal we are hardcore students of the markets. We actively study history because understanding the past makes us better traders today and in the future. History teaches that only contrarians are consistently successful. If you want to make money in the markets, you have to make the trades that few others are comfortable with. Today this is certainly betting on the endless selling ending and a big rally erupting.

Cyclical bull markets are born out of these bottoming processes just like we are witnessing today. The biggest up years in stock market history occur immediately after panic down years. Click these links and study market history yourself. The odds of this bottoming process nearing its end, and a massive rally soon erupting, are very high today. Subscribe today to our acclaimed monthly newsletter to learn about the big opportunities now and how we are positioning our own capital to ride them!

The bottom line is the stock-market action we've witnessed since late October looks uncannily similar to the bottoming process witnessed in late 2002 and early 2003. The utterly rotten sentiment, the overwhelmingly bearish SPX action, and the volatility signatures all match remarkably well. Despair reigns supreme and seemingly only fools hold out hope that things will materially improve anytime soon.

Just like back then, today it is easy to be short but sickening to be long. But I learned my expensive lesson on this mindset 6 years ago. When things look the bleakest is exactly when we need to hold our noses and buy. With the parallels between then and now uncanny in many ways, all the ingredients are in place for a monster rally. Since today looks, acts, and feels like an SPX bottom, odds are it is indeed an SPX bottom.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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