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Has the stock market sell-off bottomed? These four things will tell you when

Key Points
  • U.S. stock markets have struggled to find footing in October, and Nicholas Colas, co-founder of DataTrek Research, says there may be more room to fall.
  • He listed four metrics to use as a road map “through the minefield” in the process of finding a bottom, including sentiment on rate hikes and global equities.
  • “We don’t think the selling is over and now is not the time to bottom feed,” Colas says.
A trader works his post at the NYSE. 
Richard Drew | AP

Wall Street rebounded Thursday after a tumble in the previous session that sent two of the major indexes negative for 2018.

But the worst may not be over, according to four signposts identified by a veteran market observer. Nicholas Colas of DataTrek Research highlighted metrics to use as a "roadmap through the minefield."

"We don't think the selling is over, and now is not the time to bottom feed," said Colas, co-founder of the firm. "Watch our signals (we'll keep you updated), but stay defensive."

While Colas said he does not try to pick bottoms, he does look to spot signals that illuminate an "investable low."

"We're not there yet," he said. "We are not calling for a crash, but it is our job to help you consider risk management during periods of market stress."

Why you shouldn't panic when stocks are getting slammed

He used what he says is an old market cliche that "bottoming is a process, not an event." As a part of that process, he's watching the Fed and other global signals before calling a true bottom.

1. Fed backs off hiking talk

A key stat to watch is the odds of a Fed rate hike in December, which dropped from 81 percent to 66 percent overnight into Thursday.

"The current rout in global equities is the market's way of telling the Federal Reserve they are on the wrong course," Colas said. "Instead of lectures about an overheating economy (Bostic yesterday) or the neutral rate (Kaplan today), markets want to hear the Fed recognize global risks to growth and their potential effect on the US economy in 2019."

The central bank has already raised interest rates three times this year as the U.S. economy has heated up and is widely expected to hike again before year-end.

The agency is traditionally granted independence from presidential influence so that it can fulfill its so-called "dual mandate" of maximizing employment and fighting inflation without political interference. But President Donald Trump has doubled down on criticism of Fed Chair Jerome Powell in recent weeks and accused the agency of endangering the economy by raising rates.

2. Tech stocks vs. consumer staples stocks

Colas called this a key "go-to indicator" for market stress. Consumer staples, widely known as a defensive sector, is one of the few sectors trading in the green for the week, up nearly 2 percent in seven days. Tech, by comparison, is down more than 3 percent in the same time period.

"It essentially measures market stress by comparing the daily returns of the largest defensive sector (Staples) versus the riskiest group (Tech)," Colas said.

Based on a short-term reading, tech still needs to decline further relative to staples, he said. The market can still head lower, because tech's weighting in the is 20 percent while staples' is just 7 percent.

"Staples still need to outperform by 3 more percentage points versus Tech before any shift to defensive stocks signals unusual risk aversion," Colas said.

3. Fear gauge has to rise further

The Cboe Volatility Index is Wall Street's method for measuring fear. The VIX, as it's also called, measures how much volatility investors expect by tracking the prices of options on the S&P 500. The faster it rises, the more concerned investors are about owning risky assets like stocks.

"This is an over-referenced tool but in times of stress it is a useful one," he said.

Wednesday closed at 25, which Colas pointed out is still below the 26 to 27 levels from earlier in October.

"That's not good, considering today's decline," he said. "A real bottom would have a higher VIX."

The number to watch for is 28, he said, which is one standard deviation from the long run mean. The next level to watch is 36, which is two standard deviations away.

4. Stabilization in non-U.S. equities

Colas is keeping an eye on stocks outside of the U.S. The MSCI Emerging Markets Index is down more than 18 percent year to date and the MSCI EAFE, which tracks developed markets outside of the U.S. & Canada, is 13 percent lower.

"U.S. stocks are still better — and they should be — but international markets are flashing yellow and domestic stocks are slowing to a stop," Colas said.

The Shanghai composite has dropped more than 20 percent this year. It is one of the world's worst-performing stock markets in 2018, dragged down by worries of an economic slowdown and rising tensions with the United States, its largest trading partner.

"Stabilization here will signal that the Chinese economy isn't about to experience a sharp slowdown," he said.