August 2007 Dave Skarica, Editor Volume IX Issue VIII How to Spot a Market Bottom “He (Bernanke) has NO IDEA how bad it is out there! NO IDEA!... He has no idea NONE! And Bill Poole has NO IDEA what its like out there!... They’re nuts, they know nothing!... This is a different kind of market and the Fed is asleep. Bill Poole is a shame, he is shameful!... There are certain types of mortgages, which are available. (Announcer talking to Cramer) You can’t get a loan unless your rich like me. (Cramer’s response). Cut the Discount Rate. CUT THE RATE!” Jim Cramer Rant on Interest Rates “Cramer has more friends on Face book than Bernanke” From Mad Money A Market Bottom? Booyah! There is volatility, and then there is volatility. In the past few months we have been stopped out of the following companies: Brownstone, Trigon, Titan, Western Copper, Northland Resources, Eldorado (which was re added), Silverstone (also being re-added), Macmillan Gold, Mawson and International PBX. The good news is the average gain from our initial watch list price on these stops was nearly 50%! However, we are not going to be unrealistic here. The problem with the junior market is these stocks are so volatile and dropped so fast, we realize that many of our subscribers were not able to sell as the market plummeted. On Thursday, August 16th with the Dow down over 300 points at its depths and negativity running rampant we got fed up and issued an email alert which recommended a re purchase of Eldorado, and added stocks such as Largo Resources (LGO V), Merrill Lynch (MER V), Pinetree (PNP to), Longview (LV V), CIBC (CM TO) and Agnico Eagle (AEM V) to our watch list. We are using this time (a) pick at cheap companies, and (b) shuffle our portfolio into stocks that we will feel outperform in the next move up in the resource bull market and yes we still believe resources and the stock market as a whole are in bull markets. 1 Now we do not think the market is out of the woods yet. As you will read in this special issue on how to spot market bottoms, there is almost always a retest of the lows when these types of correction occur. Therefore, we think after a bounce here there should be a retest of the lows. In addition, there is a chance we could keep grinding lower until October. A crash seems very unlikely. Signs of a Market Bottom Technical Indicators The VIX The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and 2 puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge". There are three variations of volatility indices: the VIX tracks the S&P 500, the VXN tracks the NASDAQ 100 and the VXD tracks the Dow Jones Industrial Average. Investopedia Says... The first VIX, introduced by the CBOE in 1993, was a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors' expectations on future market volatility. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets. Source: Investopedia Out of all of them we use the VIX. As the definition says readings above 30 are signs of high volatility and under 20, complacency. Remember as the poem says “when the VIX is high, you buy when it is low you go!” You did not read a lot about the VIX in the pages of this newsletter from 2004 to 2006. The reason is that on prolonged bull moves, where there is little volatility, the VIX is not the best indicator. In the mid nineties it traded in the mid teens and the market did not correct in a large manner. The same thing occurred in the 2004 to 2006 period. Remember this is an art not a science. However, in times of volatility the VIX is an extremely good indicator to trade the market. In the 1997, 1998 corrections, the VIX pegged the market bottom to a tee. In the 2000 to 2002 bear market, the VIX spiked at every intermediate bottom in the market. We have enclosed some of these corrections to show this. Note what we have done is show the VIX in the foreground with the grey chart in the background being the S and P 500 Index. First is the 1997 “Asian Crisis” correction. Again note the VIX is not perfect at tops despite going under 20 that spring, the market continued upwards into early October. However, note the huge spike in the VIX to 38 and back to near 38 on the market’s retest of the lows. The Dow Jones fell from 8000 to 7000 during this decline. The market bottomed and then rallied to a new high in early December 1997. If you had bought when the VIX spiked to over 35 you would have made out nicely. 3 Then we have the 1998 correction bottom. The LTCM hedge fund crisis and Russian default. Again note at the markets top in July 1998 the VIX fell to under 17. It then rose to 35 when the market fell into mid August. This is a warning to us currently (the warning is that the market kept falling after a slight bounce). After bouncing around 30 for a bit the VIX rose all the way to 45 as the market fell into late August. Then again note at the markets’ retest in October, the VIX spike back to 45. 4 Anyone who bought on the spike on the VIX did quite well as the market was hitting new highs by December 1998. Then we have the Bear market of 2000 to 2002. Now despite this bear market there were a few very good trading rallies: the spring of 2000 to summer 2000, January 2001, the Spring 2001, September 2001 to January 2002. Note at the spring low in 2000 the VIX spiked to over 32. It went to over 32 in January 2001 and 35 in Spring 2001. It spiked to over 42 after 9-11 and it spiked to nearly 45 at the markets bottom in the July to October 2002 period (the October 2002 low was barely lower than the July Low) and spiked to near 35 in Spring 2003 when the market retested its 2002 lows. 5 No indicator is perfect but basically the VIX spikes near market bottoms. Basically, when the VIX starts to spike over 30 and especially over 35 (which it did on Thursday August 16th 2007) it is a good time to start to buy into the market. 6 However, one thing we noted above was that the VIX almost always respiked during market retests and bottoms. This is our second sign of a market bottom, the retest! Market Retest We are going to use the S and P 500 as the index of choice when looking at past market retests. First let’s look at the 1990 bear market. The S and P 500 fell from a peak of 370 in 1990 to a low of 295 or a loss of just about 20%. Just as a note the VIX spiked up to over 35 in both August 1990 and September 1990, not the exact bottom but in the 300 to 310 range. 7 In late September the S and P fell to 295, it did so again in Mid October 1990, then in late October after a rally to 315 if fell back to 300 before rising for the rest of the year. The S and P tested the 295 to 300 range for about a month before turning higher. In 1997 we did not see an all out retest, after falling from 980 to 880 the S and P 500 rallied to 950 then fell back to 900 in November 1997 before heading up. Again we saw a pullback to the lows before new highs. 8 1998 was totally textbook. The S and P fell from 1200 to 940 from July to August, then rallied to 1050 in September 1998 before going below the August low intra day in October 1998 but holding 940 on the close. The market then rocketed to the end of the year. 9 Finally, the 2002 to 2003 bottoming period of the 2000 to 2003 bear market. In the summer of 2002 the S and P 500 fell to 775 then rallied back to 950. It then fell back to 775 in October to a slightly lower low but it did not break the summer low in a large way. The S and P then rallied back to 950 again in December 2003 before falling back to 790 in late March 2003. The market held and it turned up. There were two retests of the low from October 2002 to March 2003. 10 Basically we can expect a retest of this low. The retests usually occur within 2 to 3 months after the initial low. So we should expect a retest of the S and P’s most recent low of 1370 in the coming months. On any such successful retest, we should see a spike in the VIX. Another interesting observation: note that almost all of the bottoms or retests mentioned above occurred in October. October – The Bear Killer Month! We all know that like the unsavoury girl in high school, October has a very bad reputation and why not after the crashes of 1987 and 1929. However, October is also the month where declines end! For example, in 1990 the bear market ended in October. In 1997 the markets correction ended in late October. In 1998 the market retested its low in October. In 2002 the market saw the final low of its bear market in October. Even the small correction that resource stocks saw in 2006 ended in early October. Therefore if we were to stabilize in the markets and retest its most recent lows 11 expect it to occur in October. October is when market declines end! The Put/Call Ratio A ratio of the trading volume of put options to call options. It is used to gauge investor sentiment. Investopedia Says... For example, a high volume of puts compared to calls indicates a bearish sentiment in the market. The ratio we watch is the CBOE Put/Call ratio and we watch the 10-day moving average, which smoothens out the readings. We find that when the average gets down to .80 to .90 you want to start watching out. For example, we saw that earlier this year before the market corrected. But, like most technical indicators this indicator tends to work better at market bottoms. The reason for this is fear is a more intense emotion than greed so the same types of panic and market behavior occur at bottoms. What we look for is the 10-day moving average of the Put/Call ratio to get over 1.10 (over 1.20 is a real extreme). For example at the March/07 low the 10-day average got to near 1.30 which was the highest level of the past 20 years (this means 1.30 puts are being purchased for every call purchased on the CBOE). In addition the 1-day readings in March and then in late July, early August were in the 1.50 to 1.70 range, again the highest levels of the past 20 years! The Put/Call ratio even on August 17ths rally was a very high 1.23. This high put/call ratio is part of the reason we think the market is in a bottom phase and will retest rather than break down. 12 Stocks Above Moving Average Among the most popular technical indicators, moving averages are used to gauge the direction of the current trend. Every type of moving average (commonly written in this tutorial as MA) is a mathematical result that is calculated by averaging a number of past data points. Once determined, the resulting average is then plotted onto a chart in order to allow traders to look at smoothed data rather than focusing on the day-to-day price fluctuations that are inherent in all financial markets. The simplest form of a moving average, appropriately known as a simple moving average (SMA), is calculated by taking the arithmetic mean of a given set of values. For example, to calculate a basic 10-day moving average you would add up the closing prices from the past 10 days and then divide the result by 10. In Figure 1, the sum of the prices for the past 10 days (110) is divided by the number of days (10) to arrive at the 10-day average. If a trader wishes to see a 50-day average instead, the same type of calculation would be made, but it would include the prices over the past 50 days. The resulting average below (11) takes into account the past 10 data points in order to give traders an idea of how an asset is priced relative to the past 10 days. 13 A very interesting indicator is the % of stocks trading above moving averages: specifically the 20, 50 and 200-day moving average. When stocks trade above their moving average it is considered bullish, below the moving average is a bearish signal. However, there are extremes. When too many stocks trade above their moving averages it is a sign that the market is over bought, too many below indicates over sold. Again we find this is a better indicator at market bottoms. At tops this indicator can take months to pan out. At tops we find that over 90% of stocks trade over their 200 day moving averages and near 90% trade above their 50 and 20 day average, but again there were 2-3 months where this occurred this year and the market kept going up. Tops are difficult to gage. However, this is an extremely effective indicator at bottoms. For example since 2000 here are the time frames that under 20% of stocks traded above their 200 day moving averages: April 2001, September 2001, late 2002 to early 2003. All great trading bottoms! We are not quite there on the 200 day moving average as only about 37% of stocks were trading above it during the most recent low. 14 However, we are there in the 50 and 20 day moving averages. At the low of this most recent sell off 8.7% of stocks were trading above their 50 day moving averages and only 6.7% above their 20 day. Other times when less than 10% of stocks traded above these two moving averages were fall 2002, spring 2003, September 2001 and April 2000, which were all good trading bottoms. In addition these two readings were the lowest since the markets bottom in the fall of 2002! I FIND THAT WHEN THESE TWO edge below 20%, which they did last week, you want to start buying the market. It may not get you the exact bottom but it will get you in close to it. I find that you want to really start buying based on the 200 day when it gets below 30%. We are not quite there yet, so again we might have to retest and bounce around before we get there. Investors Intelligence Each week the service Investors Intelligence surveys some 140 financial newsletter writers to determine whether they are leaning bullish or bearish towards the markets. What I like to do in Investors Intelligence is throw out the neutrals and divide the bulls by the bears. Usually when the bulls out number the bears by a 2 to 1 ratio and especially 2.5 to 1 the market is going to top out. This occurred at before the correction this spring and at the market top in the summer. The week of the market top the reading was 3 to 1! (Showed 55% bulls to only 18% bears!) I like market bottoms when the ratio gets under 1.5 to one and especially under 1.0. At the market bottom last May and June it got down to 1.0. At the bear market bottom in 2002 it got down to .70 meaning there were 20% more bears than bulls! I think the exact reading there was about 44% bears only 31% bulls. Again it is not perfect: as the market rallied in 2003, it showed constant readings of 3 to 1 but it kept going up. However, at market bottoms we find this like other indicators shows extremes. If the market retests, that could be enough to shake out more of the bulls and get us down to the 1.0 reading we would like to see. 15 American Association of Individual Investors This is a non-profit organization, based in Chicago, designed to educate individual investors about stocks, bonds, mutual funds, and other financial alternatives through seminars, conferences, and publications. The AAII also evaluates investment-oriented software in a publication called Computerized Investing. The AAII web site (www.aaii.org) provides extensive information on the basics of investing, as well as a reference section on a wide variety of topics such as annuities, mutual funds, dividend reinvestment plans and discount brokers. The AAII regularly polls its members for their outlook on the stock market, and the AAII Index of Bullish, Bearish and Neutral Outlook is published weekly in Barron's under Investor Sentiment Readings. Because this is a poll of individual investors, it is more erratic than Investors Intelligence. It is hit and miss. For example, at the top this past summer it really didn’t spike up and the ratio of bulls to bears was only about 1.50. However, again the readings seem to be pretty good at market bottoms. In late 2002 and during the corrections in 2005 and 2006 it went under 1.00 for weeks at a time, showing more bears than bulls. In the last week it went to 0.91. 16 Conclusion Basically, we can see most of our technical indicators are calling for a market bottom. The VIX is spiking way up. Put/Calls are high, the % of stocks below moving averages hit an extreme on August 16th and sentiment indicators are showing increased bearishness. The only real problem here is the time frame. There are very few bottoms that occur right in the middle of August. October is usually the time frame. At the least, expect some bouncing around and retests of the lows going into the fall. However, when there are bouts of panic and the VIX spikes, look to add to quality positions. Gold Stocks – Not a Hedge! In just the past 3-4 weeks Gold stocks went from almost breaking out to almost 17 breaking down. The HUI Index fell from 370 to 285 a loss over 23%! This also disproves the myth that gold stocks are a hedge. It is true that in the seventies gold stocks went crazy while the market went south. In a prolonged bear market such as 1973 to 1974, they also did well. However, it is seems when selling gets really intense gold stocks trade down with the rest of market. They crashed in 1987 and as we saw in the past few weeks when the market fell almost 10% they fell over 23%. In addition, at the end of the bear market in the summer of 2002 gold stocks were smashed. The HUI climbed to 150 in June 2002, but when the selling got really intense in the stock market the HUI fell hard to 90 or a loss of 40%. What we are trying to tell you here is when the selling gets really ugly, gold stocks usually fall with the market. The juniors are even worse cause they are so speculative. Many juniors have fallen 30 to 50% during this decline. The uranium’s have fallen 60 to 80%! Resource stocks will fall with the market. Hence, we cannot tell you enough how important it is to take profits in these things when they double and triple. You can assume that any stock on our list when it goes up 2 or 3 to 1 from our recommendation point that we are taking some money off the table as it is just prudent. If anything we have learned from this correction is that you should always try to keep at least 10-20% cash on the table so you can swoop in when corrections such as these occur. Corrections such as these can sometimes only occur every 1-2 years but it worth keeping cash so you can take advantage of them. On this decline the HUI fell to 285 on its intra day low. We consider anything under 300 to be in the buy range. There is a lot of support in the 270 to 280 area. Therefore, you should be buying when gold stocks get down to that area. If we see a retest of the markets lows and gold stocks fall with the market and the HUI again falls to 290 or so you will want to be buying down there. It should be noted that on any such retest or leg down we are going to diversify out of gold. You will see many more financials and tech stocks on this list. Techs have held up very well on this decline and we see them as leadership if/when we see a market bottom and rally. 18 Addicted to Profits Watch List Price (Watch) Current Price Current Rating EQUITY POSITIONS (NON GOLD) Large Cap Yamana (YRI T AUY NY) $3.86 (Oct 05) $11.90 ** Top mid tier, production increasing botched takeover hurting stock Stop/Loss 8 Agnico Eagle (AEM NY, Toronto) $36.50 (Aug 07) $39.48 **** Top Gold large cap ramping up production Eldorado (EGO, ELD T) $4.12 (Nov 05) $6.90 *** Solid Producer Stopped out a t5.00 for gain of 20% readded at 4.24 Merill Lynch (MER NYSE) $70.25 (Aug 07) $75.04 *** broker way to play bottoming period in market. CIBC (CM Toronto) $87.00 (August 2007) $91.00 *** Top Canadian bank hit in sell off Mid Tier Asian Dragon stopped out at 2.50 for a loss of 11% going to get back in this sucker is cheap Baja Mining (BAJ.v) $1.15 (Mar 06) $2.45 Stop Loss 1.50 *** Copper play to be put into production in 2007 Brownstone $1.80 (Feb 07) 1.75 stopped out at 1.50 for loss of 9% Capstone Gold (CSG T) $1.00 (Oct 05) $2.30 Stop 19 Loss 1.50 **** Top Silver Company, going into production, undervalued Consolidated Thompson (CLM T) $2.60 (Oct 06) $4.40 Stop Loss 4.00 **** Huge potential as a base metal play Fortuna Silver Mines (FVI V) $1.40 (Oct 05) 2.00 **** Peruvian Property in Production Unigold (UGD V) $0.46 (Oct 06) Western Silver (WRN TO) $1.54 (Feb 07) at 1.50 for loss of 3% Speculative $3.65 Stop Loss $0.88 *** DR Play $1.72 stopped out Small Cap Ammex Gold Mining (AMXG OTC) $1.15 (Aug 06) $0.32 *** Another Silver Play International Pbx (PBX V) $0.59 (Jan 06) $0.59 *** Strong Chilean Mining Play stopped out at .40 readded at .40 Largo Resources (LGO V) $0.35 (Aug 07) 0.57 *** top junior hit hard during correction Longview Partners (LV V) $0.57 (Aug 07) 0.61 *** Holding company good leveraged play Pinetree (PNP V) $3.55 sold at 5.20 for gain of 50%! In two days! Paramount Gold (PDGP Pinks) $0.90 (Oct 05) $2.30 Stop 1.80 *** AMEX LISTING! Thunderbird (formally MBA TBD) $0.30(June 06) $0.40 *** producing natural gas well Northland Resources NAU V $0.70 (Oct 05) $4.45 Stop stopped out at 400% gain!!!! Rimfire (RFM V) $1.07 (Oct 05) $1.98 Stop 1.40 *** Long term junior holding Silverstone (SST V) $0.80 (Oct 06) $2.60 *** stopped out at 2.00 for gain of 150% readded at 1.45 Micro Cap Cityview (CTVWF) $0.07 $0.09 (Dec 06) Oil play should have some more pop left, options exercised over 4 million in the bank Full Metal Minerals (FMM V) $0.80 (Oct 05) $2.60 Stop 2.25 *** Great Management, range of properties Macmillan Gold MMG $0.25 (Oct 05) $0.45 Stop 0.40 Stopped out a t .40 for a gain of 60% Mawson MAW $0.90 (June 06) $2.06 *** Stopped out at 1.85 for a gain of 106% Trigon (TEL V) .65 for a gain of 160% $0.24(July06) stopped out at Trading Positions Fury Exploration $1.00 (May 06) $0.90 broke resistance at .95 and now about to break it at 1.05 moving to main list Option and/or Short Positions None *** Mutual Fund Portfolio 20 None * Donates Close End Fund DISCLAIMER Dave Skarica and/or his family own positions in YRI, AADG, BWN.v, WRN.to, FMM, RFM, CS, SST.v, BAJ, AAB, TEL, CTVWF, CLM.v, PDGP (private placement at 0.05,), AMMEX PP at 0.50. TEL Fortuna, Capstone, FMM, and MMG are advertisers on stockchartoftheday.com Opinions expressed in this publication do not necessarily represent those of the editor or publisher, who are neither responsible nor liable for investor decisions resulting from any published selections in this report. Nothing in this publication constitutes an offer, recommendation or solicitation to buy or sell any securities mentioned. Copyright © 2007 Addicted to Profits. Reproduction in whole or in part without permission is prohibited. All rights reserved. No part of this publication may be reproduced, stored in a special system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without prior permission of the publisher. This publication contains the opinions and ideas of its authors and editors and is designed to provide useful advice in regard to the subject matter covered. However, this publication is sold with the understanding that publishers, editors and authors are not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Those involved in this publication specifically disclaim any responsibility for liability, loss or risk, personal or otherwise, that is incurred as a consequence, directly or indirectly, of the use and application of any of the contents of this publication. Notwithstanding anything to the contrary set forth herein, this publication’s officers and employees, affiliates, successors and assigns shall not, directly or indirectly, be liable, in any way, to the reader or any other person for any reliance upon the information contained herein, or inaccuracies or errors in or omissions from the publication, including, but not limited to, financial or investment data. Authors and contributors warrant that their contributions do not infringe any copyright, violate any property rights, or contain any scandalous, libelous, obscene or unlawful matter or any formula or instruction that may be inaccurate or may be injurious to the user. 21