Is this the Bottom?

The well worn saying that it is always darkest before the dawn also holds true for the stock market. Stock markets, by their very nature, are often driven more by sentiment than pure logic. When the majority of investors have thrown up their hands in frustration, it is usually an indication that a bottom is being reached. Investment market prices are based on forward looking sentiment. Investors make buying or selling decisions based on where they think the market will be in 6 months to a year in the future. In this way they are leading indicators.

So what signs do you look for to try and differentiate between a dead cat bounce and a real change in direction? In a word, capitulation.

You want to see that things have become so negative that the majority of the investors are just giving up and putting their money somewhere safe, like cash.

We saw signs of that kind of capitulation last week by Merrill Lynch. Merrill Lynch cleared all of their CDO’s off their books for 5 cents on the dollar. They agreed to unload their entire tranche to the fund Lone Star for 5 cents on the dollar in cash, with the chance to get up to a total of 22 cents on the dollar if the CDO’s recover. Anything beyond the 22 cents goes to Lone Star. This will allow John Thain, their CEO, to draw a line under the Credit Derivative debacle that cost Thain’s predecessor his job back in December.

Another sign that markets are reaching their bottom is when investors throw in the towel and sell stocks regardless of their value. You want to see a sharp rise in the number of shares hitting new lows. We saw this last month with 1304 new lows on the NYSE. This was coincident to the Dow hitting a closing low not equaled since July 2006

Market bottoms are periods of great volatility, you want to see the Volatility Index (VIX) going over 30, which it did on July 15th.

Another index which has been a very good indicator of when to buy is the American Association of Individual Investors (AAII) Sentiment Index. It is based on a survey of investors as to whether they are Bullish, Bearish or Neutral on the Stock Market. Historically, when it goes below 25% Bullish, that has indicated a market bottom. It hit 25% in the 2nd week of June and has since risen to where Bulls and Bears are just about even.

The professionals are also showing a great deal of pessimism, the Merrill Lynch Global Fund Manager Survey which measures the positions and sentiment of Fund Managers, shows that only a net 4% of managers where optimistic. It also indicated that 40% of managers said they were underweight in equities and 53% said they were overweight in cash.

Finally you want the last shoe to drop. Shares of companies in natural resources have traditionally been that last shoe. We have seen a sharp decline in Brazil, Russia, Canada and Australia, markets that have up to now weathered the crisis fairly well because of their exposure to resource extraction and basic materials.

Whether this is a rally within a bear market, or if market direction has already changed, will be decided over the next two weeks. It could be just an uptick caused by changes to the rules on shorting financial stocks in the US gaining some additional leverage on a drop in Oil Prices. Only time will tell. Either way, if this is a dead cat bounce, it is the bounce that foretold the final plunge that brought the market to its bottom.