Predicting how equities will move is usually a waste of time. However, every few years we see extreme price declines that are often followed by massive rallies (much like bungee jumping), which are sometimes short-lived bounces (like 2015) and sometimes the beginning of multi-year rallies (like 2011). For investors who have cash to allocate or want to lever up when the odds are favorable, identifying these turning points may be worthwhile. When market declines get going, I monitor to the following categories of indicators to find tradable bottoms.
Implied volatility is a rough measure of how much investors are paying for protection. The headline benchmark is the VIX (first chart below), which measures the 30 day implied volatility of the S&P 500 index. We can look at the implied volatility of different time horizons, different indices (or ETFs or individual stocks), and even the volatility of implied volatility (second chart below).
Credit spreads are an indication of how much yield investors demand. When markets are calm and perceived risk is low, credit spreads are low. When there is turbulence in markets and perceived risk is high, credit spreads widen. Although most useful in fixed-income markets, credit spreads can used as a rough proxy to evaluate fear in many asset classes.
Many oscillating indicators are based on some combination of price, time, volume, number of securities, and so on. One of the most commonly used oscillators is the Relative Strength Index (RSI) (first chart below). Another popular one is the McClellan Oscillator (second chart below).
I don’t recommend market timing to most investors, but for those who have cash to invest or who don’t mind constantly monitoring the market and taking some risk, below are some practical considerations:
- Price declines often reverse before some (or even any) indicators hit extreme levels and many indicators may not corroborate one another. Respect the weight of the evidence.
- Investors may nail the exact bottom every now and then, but it is more common to be a little bit early or a little bit late. It’s okay.
- Extreme readings do not have to mean revert. I personally like to see big reversals in implied vol, spreads, and prices (!) before buying in size. I may average into positions once extreme levels are reached, but will accelerate purchases after a reversal has gone on for 2-3 days (as I rarely trust a bounce before 1-2 days has gone by).
- There may not be a V-shaped bounce or recovery. In 2011, the market declined and then bounced around for months before rallying (for years!). Investors should not fixate on a particular scenario, but be prepared for anything.
- Investors should do their own homework, define their own risk tolerance, and use the tools that work best for them and the environment.
This post is not a commentary on the recent market volatility, but hopefully a reference for this and future selloffs.