This week the S&P 500 came within a whisker of retesting the August panic low at 1,867, before rebounding yesterday to close out what has been a dismal third-quarter for global investors.
The small-cap Russell 2000 Index actually undercut its August low this week, but so far at least, the other major U.S. stock indexes are holding.
The market is following a familiar pattern here, and if history is any guide, stocks may find a bottom soon. Let's take a closer look at the typical road map for a market bottom, and where we are now.
Stock market roadmap
There are dozens of historic examples that show stocks following a familiar bottoming pattern that typically unfolds in three distinct phases:
Phase 1: Initial sharp panic selloff
Phase 2: Intermediate bounce higher
Phase 3: Final retest of the low — or break to new lows
Take a look at the graph below, which shows the last 20% correction in the S&P 500 back in 2011, compared with the market today.
Click image for larger view
As you can see, the current path stocks are taking (orange line) is closely following the 2011 pattern (blue line). In both cases we witnessed a short but very sharp down move in August.
Next, stocks bounced higher in September, but fell short of making new highs.
Then stocks roll over again and fall back toward a retest of the panic lows. In fact, the S&P was down five of the past six sessions as of Tuesday's close.
If the S&P keeps following this roadmap, expect at the very least a retest of the 1,867 low on the S&P (and for the Dow the low is 15,370) and perhaps an undercut of that level, leading to new lows for stocks sometime in October to complete the bottoming process.
That could clear the way for a fresh market uptrend into year end. Only time will tell; just keep in mind that while history doesn't repeat exactly, it does rhyme.
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In 2011, stocks actually fell to new lows in October, which caused many investors to sell in a panic. And once that capitulation took place, the market reversed to the upside, gaining 30% over the next six months!
But how can you tell a true market bottom from a head fake? While every bottom is somewhat unique, they almost always have three important conditions in common.
Three conditions for a market bottom
#1 — Stocks get washed out: For a reliable market bottom, you need stocks to get completely washed out. Usually this happens during a retest of the panic low, or better yet, a lower low, as noted above.
Most investors get paralyzed with fear and throw in the towel at that point. And you need this kind of capitulation to form a lasting bottom.
A great indicator to keep an eye on is the number of stocks trading below their 50-day moving averages — indicating a downtrend. In a washed out market, you'll see 95% or more of S&P 500 stocks fall below this key technical level and stay there for several weeks.
In the last week of August, we briefly reached this point, but a few more weeks of extreme selling may still be needed to tell us the majority of investors have stepped to the sidelines and there is no one left to sell.
That's when stocks should be ready to rebound.
#2 — Pessimism runs rampant: Investors Intelligence keeps tabs on the advice of professional stock pickers, and right now they are the most bearish in 30 years!
In fact, the last three times bearishness sentiment ran this high — April 2009, August 2010 and October 2011 — it turned out to be a spectacular buying opportunity for stock investors with the S&P 500 gaining 20%-plus over the next six months.
#3 — Pros are almost always holding too much cash at bottoms: Lynch is famous for saying individuals almost always have an edge over big institutional investors. His advice: Steer clear of the "blundering herd," as he called them, because the Wall Street pros are almost always wrong at important turning points.
Sure enough, institutional money managers are holding over 5.5% of assets in cash, according to a recent survey of global fund managers by Merrill Lynch (see graph below). That's the highest allocation to cash since 2008!
Click image for larger view
Again, when the blundering herd moves high levels of cash to the sidelines, most of the selling pressure is already exhausted, and everyone holding cash is now a potential buyer of stocks.
Will stocks continue to follow the roadmap in 2015?
It's too soon to say that the stock market is out of the woods just yet. The bad news is the May-August 2011 decline clipped the S&P 500 for a 19% loss, while the May-August 2015 decline was only down 12%. That's why we could go even lower in the weeks ahead.
The good news is that while October has a scary reputation, it has historically been a month when stocks have made important bottoms. First, I'd like to see the market show it can hold the recent lows, accompanied by extremely negative sentiment indicators as noted above. Stay nimble in this volatile market and stay tuned.
The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.