Finding the Market Bottom

The good news is that the market is in the process of shaking out the weak longs. If Jim Cramer is right and fundamentals are going to drive the next upswing, the market needs to shake out the 'QE' buyers. Those who were long high dividend paying stocks simply for the yield, instead of underlying fundamentals, are heading for the hills. That said, I think there is more to go for several reasons.

1. Since the CBOE Volatility Index (VIX) first broke south of 20 after the melt-down of 2008, any time the VIX has moved from a relatively low level to a higher level and then eventually breaks through 20, it almost always has some follow through. The lone exception was the fiscal cliff deal.

VIX 2008-2013
Source: TD Ameritrade


Basically if we look at a chart of the VIX and the SPX since the beginning of May there is currently no sign that this is going to end. The VIX keeps climbing and the SPX keeps breaking.
VIX and SPX May 2013-June 2013
Source: TD Ameritrade


This is a pattern that says SPX is going lower and the VIX is going higher.

If we look at how 2011 played out, we can see how the VIX started climbing and the SPX started dropping...aggressively, well before there was any downgrade in the US. The downgrade marketed a total VIX spike (we may or may not get that). That spike was a sign that the market was in turmoil. Once the SPX broke lower in October and VIX failed to follow, with further evidence of both SPX and VIX failing to hit new high/lows in November, it was a clear sign to buy (and was it ever).

VIX and SPX 2011
Source: TD Ameritrade


The other piece of this puzzle is bonds. If investors think the equity markets looks ugly take a look at the destruction of the 10 year note in the last month. Earlier in the year, the market was acting somewhat normal. When bonds would sell off, stocks would rally....this is the way things are SUPPOSED to work. Now look at the last two large sell offs in the 10 year note, what happens to SPX....IT DIVES.

 
SPX and 10-Year Bonds
Source: TD Ameritrade

 

I am convinced that until the 10 year note and the SPX move back toward their normal correlation that we are going to have continued rough waters. The 10 year note is causing turmoil everywhere until yields stop rallying at aggressive rates, the SPX is going to have issues.

Summary:

Look for bonds and stocks to normalize, look for the VIX to fail on an SPX sell-off and then we will be at our floor. Right now the weak are being shaken out, the momo buyers. As the VIX rallies, I would be looking to sell puts in S&P 500 (SPY) around the 1,525-1,550 level as a way of getting long the market. Those that are longer term investors might look to sell a SPY put at the 152 level around the September or October time frame. I think there is a strong chance that the return on a put sold at that level works out well.

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Mark can be followed on Twitter at twitter.com/OptionPit.

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