Bottoming Process

From ShortsideofLong Blog:

The number of NYSE 52 week new lows jumped to 1342 during Monday

Stock Market BreadthSource: Short Side of Long

Earlier in the week we discussed the fact that US equities are currently going through a crash. The same is true for just about all global equity indices. The first two charts in this post show the panic selling we are currently experiencing. On Monday the Volatility Index (VIX) spiked above 50 (second highest level in two and half decades) and the number of New York Stock Exchange 52 week lows jumped to 1342 issues (highest since 2011 Eurozone Recession).

Furthermore, the chart earlier in the week also showed that the VIX spike was so surprising with market participants completely caught of guard. The so called fear gauge jumped 230% above its 200 day moving average, which is second highest on record and only behind the catastrophic 1987 crash.

We have circled all the capitulations during the previous two decades in the chart below. The facts are, whether the trend is bullish or bearish, VIX spikes almost always signal an intermediate degree bottom at hand. In other words, 3 to 9 months out, stock markets usually rally strongly even if it ends up being a dead cat bounces.

At its highest high, VIX index spiked into the capitulation zone 

Volatility IndexSource: Short Side of Long

With capitulation in progress, should we buy immediately? Definitely not. Prudent investors need to understand how previous panics have bottomed out. The chart below shows all the crash events and their bottoming process post the VIX spikes (includes all major sell offs from 1987 until present). Let us make a few observations.

Firstly, it is important to note that 2001 sell off was the only one to bottom on a V trough, while all others went through a double or a triple bottom. Furthermore, certain sell off events were mild relative to some of the other crashes. Half of the sell offs since 1980s  were smaller than 20%, while the other half were larger. It is important to remember that smaller sell offs usually occur during external events such as Japanese Bust in 1990, Emerging Markets Crisis in 1998 and Eurozone Crisis in 2010/11. The current sell off is sparked by Emerging Market recession and Chinese slowdown.

We will continue to post this analogue in coming weeks as we track the bottoming process and the up-and-coming buying opportunity in stocks.

As VIX Index spikes the bottoming process can take anywhere from 1 to 4 months

Stock Market BottomingSource: Short Side of Long