Once a short-term transition from overly bullish to overly bearish begins, sentiment and channel lines can be your two best friends to help you keep your sanity. Whatever you do, turn off the media or you'll be waiting for The Great Depression 2.0. I've always found sentiment as a very solid indicator of tops and bottoms, but especially bottoms. Nothing marks a bottom like a good old-fashioned panicked selloff with capitulatory-type volume. The panic doesn't usually end until the baby goes out with the bath water and the kitchen sink.
Cyclical Bear Market Lows
Shallow pullbacks in secular bull markets can see capitulatory bottoms from time to time before rising back to all-time highs. Unfortunately, cyclical bear markets generally see more than one of these bottoms form before the ultimate bottom is established. Let's look at the 3 key lows on the S&P 500 chart below:
All 3 lows were accompanied by VIX readings in the mid- to upper-30s. If you think this is coincidence, think again. Here's a longer-term chart that shows many bottoms printing once the VIX moves into the 30s and 40s:
The VIX is one sentiment reading that helps us identify when the baby is being thrown out with the bath water. When the stock market grows incredibly fearful, rational technical behavior can usually be tossed. Bottoms typically are defined by these elevated VIX readings.
We can also count on retail options traders, who tend to be followers. As sentiment shifts too far in the bearish direction, we can almost always count on options traders to pour into put options, sending the equity only put call ratio ($CPCE) soaring to an extreme. Check out the 5-day moving average of the CPCE and how it has successfully marked major market bottoms:
This chart would suggest that options traders haven't yet grown bearish enough to mark a significant bottom. We would likely need significantly more selling to drive options traders over the edge and into a panicked frenzy.
While the 2022 selling-to-date has helped relieve some sentiment issues, I still believe it's more likely that we'll see further market weakness and higher CPCE readings before a major market bottom is established.
Key Channel Line Resistance
Here is an excerpt from my Daily Market Report (DMR) to EarningsBeats.com members from this past Thursday:
"Let's keep the focus on the NASDAQ 100's ($NDX) hourly chart. We just saw a slight negative divergence form today on the rally past the February 28th high. Combine that with the channel test above and I believe this is a great opportunity to short, if that's your preference. It's most definitely not a guarantee to profits. Rather, it's simply a solid reward-to-risk short entry point where you can exit quickly if we see a rally later today. Here's that divergence:
The absolute first step that the bulls must take is breaking out of this current down channel. The negative divergence on the hourly chart occurred simultaneously with a channel line (resistance) test. The trend here is clearly lower. Given a VIX that's currently at 31.98, moves in both directions are likely to be amplified. But watch this channel. While a break to the upside wouldn't necessarily suggest the 2022 selling is over, it would at least require a "re-evaluation" of key market signals.
Patience Required
On Saturday, February 12th, I hosted the 2nd part of our February Educational Series. It was "The Anatomy of a Cyclical Bear Market" that detailed the characteristics of every cyclical bear market since 1950. The purpose of this educational event was to provide our EarningsBeats.com members with knowledge of what to expect. Cyclical bear markets require patience, much more so that the typical, quick pullbacks within a secular bull market. Instead of lasting a week or two, most cyclical bear markets last a quarter or more. So if you're constantly trying to call a market bottom, because of a pre-conceived bullish bias, it grows incredibly painful and expensive. You MUST let these bear markets play out over time. March has all the makings of a very difficult month, with perhaps more pain than either January or February. The next CPI report will be released this Thursday. Shortly thereafter, be prepared for the Fed's next fiasco. If we are likely to see another leg lower in this cyclical bear market, the March version could be the biggest and swiftest yet.
In the end, it will likely create the type of opportunities that only come along once a year or even once every few years. But it will require much more patience than we've been accustomed to over the past couple years.
Conclusion
Just be careful. My commentary at MarketVision 2022 on Saturday, January 8th has been absolutely spot on. The constant warnings of a risky market environment ahead have already paid off. I have consistently suggested cash and gold ($GOLD) as alternatives to "riding this thing out". I've also provided key setups for short entries for those wishing to profit from market weakness. I began taking profits in gold last week for a couple reasons. The primary reason is that gold benefits from fear and, with a VIX in the 30s, gold has been cruising to the upside and substantially outperforming the S&P 500. What's wrong with taking profits along the way? I think it's the responsible thing to do. Gold has definitely helped to bolster returns during a difficult period for the stock market. But there is a second problem for gold, one that nearly always puts a lid on a gold advance. That is my topic for tomorrow's free EB Digest newsletter. To receive that and to understand why gold could be extremely vulnerable in the near-term, CLICK HERE to register with your name and email address. There is no credit card required and you may unsubscribe at any time.
Happy trading!
Tom
