As has happened numerous times in history, the markets mounted a high volatility rally after the approximately 10 sigma selloff experienced last week.  Panic and euphoria are always lurking in markets and will serve to draw people into their respective manias at the worst times.

We have pointed out that there are many signs to look for to determine where markets may bottom after a violent sell off as recently witnessed.  There are many indicators and some of them may be too esoteric for readers, but here are some of the major things to assess in gauging the end of a violent selloff:

Abnormally high volatility readings on VIX: prices substantially below previously up-trending moving averages: a slowing of rate of change indicator: prices at previous levels of breakout or support or at fibonacci levels: very high volume: price bars that open, go lower and then close near unchanged for the period, (a pattern labelled as a doji in candlestick chart parlance).   These are tools that are available to most anyone with access to simple technical analysis features.  For more in depth analysis, we can look at such things as options volatility pricing.

Once prices ‘bottom’ however, what happens next is still unknown and will depend on factors not yet clear to market participants.  Markets are never exactly the same, but many patterns do repeat. Typically, the issue will rally but then meet some supply as traders who were caught at higher prices sell into the first rally.  Previous price lows become resistance but fibonacci calculations are useful targets as well.  It is the subsequent ‘test’ of the recent low which will give further confirmation of whether the issue has really bottomed or is merely a pause for further selling.

In simplistic terms, the level to which prices retrace, the associated volume and the level of momentum indicators at the test levels will give further clues as to price direction.  We can never know for a certainty, but objective evidence can be collected to make  rational buy or sell decisions.

What is most useful for traders during this time of uncertainty is to analyze the activity of issues that are in the same general space.  For illustration purposes, the chart below (courtesy of Stockcharts.com) shows a performance comparison of Visa, Mastercard and American Express, all in similar businesses.

As we can see, while all 3 issues move somewhat similarly, there is a clear performance difference among them.  In this case, notice that Mastercard has generally outperformed both Visa and American Express both on the advance AND the selloff.  In other words, MA was much more resilient on the decline and has bounced back more rapidly than have the others, notably AXP.  This observation is key when making investment and trading decisions.  Relative strength is critical when assessing investment alternatives.

In the same way, we perform such relative strength analysis on the overall market indices, then to discrete sectors, before drilling down to specific issues within those sectors.  Even if markets don’t advance as projected, employing these tactics will reduce traders’ chances of entering the worst performers.

All this is predicated on the notion that existing trends are intact and have not been damaged by the selloff.  How do we know if this is the case?  We will discuss another very important factor in determining this in the next post.