Technical Analysis
A Bounce, Not A Bottom
The STI has recently experienced a very sharp decline along with the major indices
in the world. This has put the STI in severely oversold territory on the daily and
weekly charts. In this report, we will be contrasting the current oversold conditions
with previous incidences in history to give us a perspective of the current bear market
rally. We will also be touching on the duration of declines. For this report, we are
using 2.5 standard deviations for the weekly charts and 2.0 for the daily.
STI Weekly, October 2008
In the chart above, the white bands represent 2.5 standard deviations. Given
normally distributed data, 99% of price action should fall within the bands. Examining
the STI, we see that last week the market closed outside 2.5 standard deviations
(circled in white). In addition, examining the Relative Strength Index (RSI) in the
indicator window (also circled in white) we see the weekly RSI in deep oversold
territory as well. This makes the case for a reversion in the direction of the mean from
current levels. A deeply oversold weekly RSI with a close outside 2.5 standard
deviations is a rare occurrence. In the past 10 years of STI data, there have been
only 5 such occurrences. We examine the other 4 in the report.
STI Daily, October 2008
For the daily charts of the STI, we see a similar occurrence of this phenomenon that
occurred in the weekly charts. Last Friday's trading session closed outside 2.0
standard deviations with a severely oversold RSI as well. Oversold readings on the
weekly and daily levels are the most likely reason for the recent bounce.
STI Daily, January 2008
A similar case can be seen in January 2008 when price closed fully outside 2.0
standard deviations after a sharp sell off. What resulted was a small rally reverting
back within the standard deviation bands.
Previous Incidences of Deeply Oversold Conditions
We will now examine some historical incidences of similar price extremes to get a
gauge for how the current market might possibly behave.
STI Weekly, 2001
In the bear market coming off from the Dot-com bust in 2000, there were two
incidences of closes outside 2.5 standard deviations with oversold RSI. Incident "(1)"
during March 2001 was mild with RSI barely dipping below the oversold mark and a
weak close beyond 2.5 standard deviations. As a result price drifted lower before a
mild upswing and a long consolidation. Incident "(2)" in September 2001 was more
similar to the current oversold condition we are seeing now. The market closed
strongly outside the standard deviation bands and the RSI was deeply oversold
resulting in a sharp rally.
However, the main difference between September 2001 and the current market
condition is the duration of the decline. The bear market began in January 2000 and
the market had already been declining steadily for 19 to 20 months by September
2001. Currently we are only 12 months into the decline from the October 2007 high
and the probability of a sharp rally similar in length and magnitude as the September
2001 is not high. We touch more on the duration of declines in the next section.
STI Weekly, Decline from February 1997
The other 2 incidences occurred during the decline coming off from the Asian Crisis
in 1997. Again we see a close outside 2.5 standard deviations for incidence "(3)" and
"(4)" along with deeply oversold RSI conditions as well. Please draw your attention to
what happened after in these cases. In incident "(3)" during October 1997, prices
rallied off from the low and drifted sideways before declining. For incident "(4)" in
January 1998 there was a run up for a month followed by a consolidation before the
decline continued all the way down to the 800 level.
Duration of Decline
The duration the market has been declining is a key factor in determining whether the
market will rally strongly in the light of oversold conditions. To use an extreme
example for the sake of illustration, it is impossible for a bear market like the current
one, driven by a credit crisis and deleveraging of unprecedented scale to end in a
very short period of time, E.G.: 3 months from the October 2007 high. Time is
required for the excess that worked its way into the market since 2003 to be ironed
out and investor sentiment to change. In our Q4 Strategy Outlook, we made the
observation that the minimum duration of decline from crisis situations is at least 19
months.
STI Monthly, Bear Market of 1997
The bear market of 1997 took a minimum of 19 months to unravel completely.
Incident "(4)" discussed above, occurred about 12 months from the top in February
1997. From the chart here, we can observe that the Incident "(4)" bounce was a
minor rally during the bear market. Also note that the decline from the high was
approximately 63%.
STI Monthly, Current Bear Market of 2007
To put the current situation into perspective, even though we are seeing a deeply
oversold RSI and a close beyond 2.5 standard deviations in the weekly charts, we
are only 12 months into the decline and about 50% from the high. The 50% mark is
our initial target, as outlined in our Q4 Strategy Outlook.
Conclusion
It is highly unlikely that this bounce is a bottom. We argue that this Credit Crisis is
more severe than the Asian Financial Crisis and we estimate the severity and
duration of the decline to be at least equal that of 1997. If history is a good reference
point, the 1997 benchmark would place at least another 7 months left before we see
any sustainable rally and a final STI reading in the 1400 to 1500 region (63% decline).
Extreme oversold conditions occur during sharp sell offs, but in the context of a major
downtrend, such mean reversions are usually short-term moves where the market
takes a breather before continuing the trend. We advise readers to avoid being
unduly bullish during the minor up moves that will occur during this downtrend in the
STI.
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