Market bears not out of the woods yet

Is the end of the crisis nigh? Proinsias O'Mahonyexamines the indicators that suggest there are reasons to be cheerful

WARREN BUFFETT famously quipped that you have to be greedy when others are fearful and fearful when others are greedy. With global markets in freefall, is this the time to be putting money to work? Contrarians with strong stomachs might be tempted by a mixture of fundamental, technical and (sometimes surreal) anecdotal evidence.

SMART MONEY IS LOOKING LONG

The smart money has been bearish for some time. Right now though, many bears are positioning themselves for a decent bounce.

High-profile short-seller Doug Kass writes that his investment disposition "is now turning sunny" on the grounds that hedge funds are aggressively shorting index futures contracts in order to "hedge their cratering longs" - a "classic tactic one sees at panic/capitulation lows".

Marc "Dr Doom" Faber's reading of sentiment and technical data led him to predict that October will see a powerful bear market rally. American analyst Barry Ritholtz has been another high-profile bear but lately he's spotted "a list of contrary indicators that suggests things are getting overdone".

Even Albert Edwards, the notoriously bearish Société Générale analyst who has repeatedly warned of an equity "ice age", recently suggested that the "usual array of indicators suggests a strong bounce is now very possible".

Verdict:It's always encouraging to see smart bears turn bullish, even if it's only in the short term. Longer term, many remain bearish.

BUFFETT IS BUYING

The Sage of Omaha has been busy of late, injecting $8 billion into Goldman Sachs and General Electric. Proof that stocks are cheap?

Verdict:Not really. "Looks good as a headline, is godawful underneath," said Barry Ritholtz, pointing out that both deals were secured at very favourable terms to Buffett unavailable to ordinary investors. "Warren is not so much making a vote of confidence as he is extracting a pound of flesh," Ritholtz added.

MARKETS ARE AT OVERSOLD LEVELS THAT INVARIABLY LEAD TO RALLIES

Incredibly, less than 3 per cent of SP 500 stocks are trading above their 50-day moving average. Only twice in the last year have single-digit readings been recorded, with strong bounces occurring on both occasions. One has to go back to the summer of 2002 and the aftermath of 9/11 to find the next single-digit readings. Fierce rallies ensued on both occasions, with the 2002 low marking the bottom of a three-year bear market. The latest reading is the lowest since Black Monday in 1987. Similar analysis is used by analysts at Bespoke Investment Group, who concluded this week that "a significant rally is set to take place".

Verdict:As technical signals go, they don't get much more reliable than this one. A caveat is that one could have made the same points last week - and look what's happened since.

PANIC LEVELS ARE AT ALL-TIME HIGHS

The VIX, an options volatility index that is often referred to as the "fear index", recently spiked to above 50 - its highest reading since its introduction in 1993.

Without getting into the mechanics involved, suffice to say that readings in the 35 range have marked tradable bottoms on four occasions since the bear market began last year. During the 2000-2003 bear market, readings above 35 were followed by strong rallies on all five occasions.

Verdict:Contrarians will be encouraged by this confirmation of generalised panic. Note that the latest reading is completely off the charts, however, and that those who bought on the basis of a high VIX a fortnight ago have got their fingers burnt.

BLOG VISITS

Mike Seneadza, an American trader and founder of the popular TraderMike.net blog, recently noted that a spike in site visitors looking for information on inverse ETFs - funds that allow one to profit from a declining market - tend to indicate a selling climax. With the Dow suffering intra-day losses of 7 per cent on one terrible day this week, Seneadza observed that "74 per cent of my traffic was from people looking for inverse ETFs".

Verdict:It's just an anecdote, of course, although several well-known trading blogs have related similar tales in the past. A more amusing tell-tale sign is the setting up of a hilarious new pictorial blog called Sad Guys on Trading Floors. "A blog such as this could only be conceived of during times of extreme market stress," writes Barry Ritholtz.

OTHER SURREAL ANECDOTES

"Whatever money you may need for the next five years, please take it out of the stock market right now." That was madcap CNBC host Jim Cramer this week, just weeks after he said the market had bottomed. Cramer's panic, allied to his reputation as an awful market-timer ("We have Armageddon!", he screamed in an on-air meltdown last year, before predicting new highs for the Dow weeks later), had many predicting a near-term bottom.

Time magazine's latest cover, featuring a Depression-era picture of men queuing up outside a soup kitchen, was just the latest in a string of apocalyptic magazine covers. The Magazine Cover Indicator states that a theme is nearing its end when it's emblazoned all over the mainstream press.

Verdict:Believe it or not, research shows that the magazine indicator has merit. Don't bet the farm on it, however.

STOCKS ARE CHEAP AND THE BAILOUT WILL HELP

The SP 500 is trading at a forward price/earnings ratio of 11.9, way below the 10-year average of 19.8. Globally, stocks have fallen by 41 per cent since last October. Goldman Sachs say that economies take an average of 2-2.5 years to recover from a financial crisis but stocks bottom after about a year - around now, in other words.

Verdict:Not as good as it sounds. Analyst earnings estimates for 2009 are too high, so forward price/earnings ratios are likely unreliable, especially in a deeply recessionary environment.

UK firm Smithers Co says that historical P/E analysis suggests that the market remains overvalued. Smithers's research finds that stocks have been overvalued for two decades so investors should not get too excited by the fact that stocks are trading at a discount to the inflated valuations of the last 10 years. Regarding Goldman, it's fair to say that this is no ordinary financial crisis. Still, other research confirms that bailouts help economies and stocks are certainly cheaper than they were last year.

SENTIMENT SURVEYS

Nearly six out of 10 Americans believe another economic depression is likely, according to a CNN poll this week. Sentiment surveys by the American Association of Individual Investors reveal that more than 50 per cent are bearish in outlook. A "dumb money" indicator, AAII investors are ordinarily bullish but tend to get spooked after heavy market falls.

Verdict:Bearish AAII readings have consistently proven to be a very fine indicator of a near-term rally, even during the present bear market. However, the latest reading remains below extremes recorded earlier this year.

PANIC-SELLING BY HEDGE FUNDS IS EXACERBATING MARKET FALLS

"The single biggest reason the stock market has fallen in the past five days is hedge fund liquidations," writes financial commentator and hedge fund manager James Altucher. "Of the top 20 hedge funds in the world, something like 18 are down 20 per cent or more this year. They are selling stocks with reckless abandon to raise cash. Our job as good investors is to give them liquidity and take their bargain-basement merchandise off of their hands."

Verdict:Altucher's conviction belies the fact that he has no real proof of what "the single biggest reason" might be.

However, hedge funds have had their worst year in two decades and there's a lot of evidence of mass redemptions - so he may not be too far off the mark.

Overall verdict:While these are not ordinary times, the wealth of technical and anecdotal evidence suggests that markets "should" be near an intermediate bottom. It's much more difficult to say if a long-term bottom is near, however.