How to Trade a Potential Stock Market Bottom

This column was originally published in two parts on RealMoney: part one on Feb. 12, 2008 at 1:29 p.m. EDT and part two on Feb. 13, 2008 at 9:49 a.m. EDT. Both parts are being republished in one column as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Four Macro Characteristics That Are Indicative of a Stock Market Low

We have been seeing some more positive characteristics in the stock market of late. As we point out these improvements, we have had some questions as to whether we are getting more bullish. We can't say no to that question, but we thought going through our reasoning in slightly more detail would clarify our position.

We like to think of things in probabilities or from the standpoint of permissive conditions. When X occurs, there is a probability Y will follow, and this means we can do Z to take advantage of the situation. Here is where we are and how we currently see things. We have broken these points down into two parts and will finish our argument.

Low Characteristic 1: Oversold Levels

The most compelling piece of data we have is our long-term SARSI indicator. This indicator has reached oversold levels pushing down into the low double digits for the S&P 500 and total market. It has been five years since the last time this reading occurred at the 2002 bear market lows.

Over the last 20 years going back to the 1987 crash, once this indicator has reached a similar reading, the market has begun to weave a bottom. Sometimes these were tradable rallies, and sometimes they marked the beginning of a longer multi-year bull run. No matter what, though, they have told us the majority of the damage was done and the worst was behind us. This is a long-term indicator, and as such, it takes time to improve. This means we should expect any recovery to take weeks and months not days.

On a long-term basis, there is a good chance the lows are in. It could stay here longer or chop around further, that too is normal. In fact, in previous readings of this level, it took three months before the rally got underway.

Low Characteristic 2: Bearish Sentiment

The second thing is the sentiment. It took some very dramatic declines and intense fear to do it in recent weeks, but sentiment has finally turned cautious to bearish. We have seen short interest increase tracking near all-time high levels. On Tuesday [Feb. 12], short selling as a percentage of all volume was the highest one-day level in 70 years. Traders have figured out it's a bear market and to sell rallies . This in and of itself is not a force to push stocks higher, but it is another potential catalyst on the upside.

So far, the short-sellers have been right. However, when sentiment shifts this much and with this level of conviction, it eventually results in a swing the other way. This creates a situation where any buying can force these traders back into the market to either cover shorts or get reinvested.

Consumer Discretionary Sector Select SPDR

Click here for larger image.

How to Trade an Oversold and Bearish Market

One way to take advantage of these two points is by looking for a recovery in the most punished sectors. The two that come to mind are consumer discretionary and financials. While we believe the financials have seen the worst of the selling, they still have been struggling. The consumer discretionary sector is beginning to benefit from not only the extreme technical oversold condition, but some anticipation the friendly interest-rate environment will eventually spark the economy. We would be buyers of the Consumer Discretionary Select SPDR (XLY) at current levels and expect further strength to the $34 level, near-term, with the potential for a move to $36 longer-term.

On Tuesday [Feb. 12], we identified the first two of four macro characteristics that are associated with lows in the market. Today [Feb. 13], we will finish our argument regarding a potential low. We want to emphasize that these characteristics are indicative of a low, but do not mean a low has been reached. We expect continued volatility and a few more starts and stops before they take hold. These are permissive conditions that suggest we can be more opportunistic on the long side.