Stock market bottom


Stock market bottom

A stock market bottom is a trend reversal that marks the end of a market downturn and the beginning of an upward moving trend. A "bottom" may occur because of the presence of a cycle, or because of panic selling as a reaction to an adverse financial development.

It is easy to identify a bottom in hindsight but very difficult to identify a bottom (referred to by investors as "bottom picking") while it is occurring. This is because the upturn following a decline is often shortlived and results in a continued price decline and hence a loss of capital for the investor who purchased stock(s) during a misperceived or "fake" market bottom.

Some of the more notable market bottoms, in terms of the closing values of the Dow Jones Industrial Average (DJIA) include:
*Black Monday: The DJIA hit a bottom at 1738.74 on 10/19/1987, as a result of the decline from 2722.41 on 8/25/1987 (Chart [http://stockcharts.com/h-sc/ui?s=$INDU&p=D&st=1987-08-01&en=1987-12-31&id=p95907824619 stockcharts.com chart] ).
* The bursting of the Dot-com bubble: A bottom of 7286.27 was reached on the DJIA on 10/9/2002 as a result of the decline from 11722.98 on 1/14/2000. This included an intermediate bottom of 8235.81 on 9/21/2001 which led to an intermediate top of 10635.25 on 3/19/2002 (Chart [http://stockcharts.com/h-sc/ui?s=$INDU&p=D&st=2000-01-01&en=2002-12-31&id=p94927308656 stockcharts.com chart] ).

A decline associated with the Subprime mortgage crisis starting at 14164.41 on 10/9/2007 (DJIA) and caused a short term bottom of 11740.15 on 3/10/2008. After a rallying to a temporary top on 5/2/2008 at 13058.20 the primary trend of the declining, "bear" market, resumed. (Chart [http://stockcharts.com/h-sc/ui?s=$INDU&p=D&st=2007-06-01&en=2008-12-31&id=p30570128154 stockcharts.com chart] ).

Baron Rothschild is said to have advised that the best time to buy is when there is "blood in the streets", i.e. when the markets have fallen drastically and investor sentiment is extremely negative [http://www.fool.com/investing/small-cap/2007/05/02/buy-when-theres-blood-in-the-streets.aspx Buy When There's Blood in the Streets] . At that time adherants of the trend following approach have already exited the market, however those who view the stock markets as a cyclical process and feel they have clearly "picked a bottom", would become interested in buying because this is when profit potential is at it's peak.

An investor who enters the market at a perceived bottom has concluded: [http://www.thestreet.com/university/personalfinance/10403399.html How to Trade a Potential Stock Market Bottom] :

* The market has fallen to such a degree that the current price is far below normal expected values.
* The market is not likely to fall further.
* A valid uptrend is about to begin.

Identifying a market bottom

*Market valuation (Long term indicator): A proper market valuation is accomplished by considering both earnings and earnings growth using a formal Discounted Cash Flow Model. Some of the organizations who perform proper market valuations are:
**Morningstar [http://www.morningstar.com/cover/pfvgraph.html Market Valuation Graph] uses a market valuation graph giving the ratio of price to fair value for the median stock in each coverage universe over time. A ratio below 1.00 indicates that the stock's price is lower than the estimate of its fair value. Another common but slightly less accurate method of market valuation is to utilize the company's profit and earnings P/E ratio.
**Valueline's VLMAP (market appreciation potential) attempts to project a stock's appreciation over the next 3-5 years [http://www.valueline.com/why_use_potential.html An Evaluation of Value Line's 3- to 5- Year Price Appreciation Potential] . Its use has been studied by Peter Bernstein and Dan Seiver, who uses it in his PAD system report [http://www.marketwatch.com/news/story/market-timing-model-based-value/story.aspx?guid=%7BD4DA196B%2DEB00%2D4E2B%2D9414%2D577F0939B2FF%7D An obscure market-timing indicator has turned positive] . When the Valueline indicator rises above 100, it is taken to be a buy signal. This method of measurement gave buy signals during the bottoms of October 2002 and March 2003, and the panic low immediately following the 9/11 terrorist attacks. However its record as a sell indicator (at a market top) is thought by many to be questionable [http://www.marketwatch.com/News/Story/Story.aspx?guid=%7B0A64D532-D6D4-4A13-B772-DA9581629090%7D A gloomy four-year forecast] .

*Investor sentiment (Long term indicator): When an extremely large percentage of investors and financial advisors express a bearish (negative) sentiment, it is a strong signal that a market bottom may be near. However the predictive capabilities of this kind of investor sentiment (see also market sentiment) are thought to be highest when investor sentiment reaches extreme values. Indicators that measure investor sentiment may include:
**Investor Intelligence Sentiment Index [http://www.investopedia.com/articles/trading/03/100103.asp Investors Intelligence Sentiment Index by Jason Van Bergen] , [Chart: http://www.market-harmonics.com/free-charts/sentiment/investors_intelligence.htm Chart] : If the Bull-Bear spread (% of Bulls - % of Bears) is close to a historical low, it may signal a bottom. On July 22, 2008 it stood at -20.20%, a remarkably low value for past three year period.
**American Association of Individual Investors (AAII) sentiment indicator [ [http://investmentscientist.com/2008/03/27/ 2008 March 27 « The Investment Scientist ] ] : Many feel that the majority of the decline has already occurred once this indicator gives a reading of minus 15% or below.
**Mark Hulbert's Stock Newsletter Sentiment Index (HSNSI) [http://www.cxoadvisory.com/gurus/Hulbert/ Mark Hulbert's Stock Newsletter Sentiment Index] : During the March 2008 bottom this indicator gave a reading of minus 29.4% [http://www.marketwatch.com/news/story/towel-hasnt-been-thrown-yet/story.aspx?guid=%7BAF4600C4-D354-4A9F-BA58-9CB21630E33B%7D&dist=msr_1 Contrarians see no sign of capitulation that marks bottom] . As of June 30, 2008, it stood at minus 35.9, which was its lowest value in a decade.
**Other sentiment indicators include the Nova-Ursa ratio [http://www.schaeffersresearch.com/streetools/market_tools/rydex_nu.aspx Rydex Nova/Ursa Ratio] [http://www.market-harmonics.com/free-charts/sentiment/nu.htm Rydex Funds Nova/Ursa Sentiment Ratio] [http://www.wallstreetcourier.com/technician/market-indicators/rydex-nova-ursa-ratio.htm Rydex Nova/Ursa ratio] , and Short Interest/Total Market Float [http://bigpicture.typepad.com/comments/2007/05/short_interest.html Relative Short Interest/Total Market Float] [http://www.gold-eagle.com/editorials_05/to082205.html NYSE Short Interest Again At All-Time High]

*Market oversold indicators:
**Relative strength index (RSI)is a momentum indicator that compares recent gains to recent losses. It is measured in values between 0 and 100. When the RSI is below 30, the market or stock is considered to be significantly oversold and therefore undervalued. For example here is an RSI chart for the NASDAQ Composite: [http://moneycentral.msn.com/investor/charts/chartdl.aspx?PT=7&compsyms=&D4=1&DD=1&D5=0&DCS=2&MA0=0&MA1=0&CP=1&C5=1&C5D=1&C6=2004&C7=8&C7D=30&C8=2008&C9=-1&CF=16&D7=&D6=&showchartbt=Redraw+chart&symbol=%24COMPX&nocookie=1&SZ=0]
**Greatly Undervalued securities: Prices that are below several multiples (2 to 4) of the standard deviation from the 50-day moving average [http://www.marketwatch.com/news/story/look-market-bottom/story.aspx?guid=%7BA81CB578-0F34-11D5-B64F-00A0C9EF346A%7D What to look for in a market bottomBy Roy Blumberg] . For example here is the chart for NASDAQ Composite MA with 2% deviation [http://bigcharts.marketwatch.com/charts/big.chart?symb=qqqq&compidx=aaaaa%3A0&ma=0&maval=50&uf=4&lf=268435456&lf2=0&lf3=0&type=2&size=3&state=8&sid=2666326&style=320&time=8&freq=1&comp=NO%5FSYMBOL%5FCHOSEN&nosettings=1&rand=7454&mocktick=1] :
**'Standard and Poor's (S&P) oscillator': This is a proprietary tool offerred by Standard and Poor's, a renowned investiment research company and one can access the S&P oscillator through a paid subscription with S&P. Standard and Poor's [ [http://www.cnbc.com/id/25142167 Mad Money: Game Plan: Expect a Rally - Game Plan - CNBC.com ] ] [ [http://www2.standardandpoors.com/portal/site/sp/en/us/page.product/equityresearch_oscillator/2,5,13,0,0,0,0,0,0,0,0,0,0,0,0,0.html Standard & Poor's - Oscillator ] ] , This oscillator is thought to be based on a formula [http://www.sentimentrader.com/subscriber/price_oscillator_sp_description.htm PRICE OSCILLATOR - S&P 500] originally proposed by George Angell. For a given bar, it is given by "((High - Open) + (Close - Low)) / (100*2 * (High - Low)) minus 50%"; market lows are supposed to be marked by minus 4% to minus 9% (i.e. 4 to 9% below average).

*Market capitulation: In a severe down trending market there may be a certain threshold after which large numbers of investors can no longer tolerate the financial losses incurred as a result of the current downturn. [http://online.wsj.com/article/SB121685817512279283.html?mod=rss_whats_news_us_business Ellison's New Position: Cash Hoard, By Diya Gullapalli, "I don't want to lose any more ...] . This majority group of investors then capitulates (gives up) and sells in panic or finds that their pre-set sell stops have been triggered thereby automatically liquidating their shares of a given stock. This dramatic increase in the number of sellers causes a further increase in the speed and severity of the stock's price decline. In other words market capitulation occurs when there is a sudden steep decline in price caused by high volume selling [http://www.streetauthority.com/terms/volumedownside.asp CLIMACTIC DOWNSIDE VOLUME AND SWING TRADING OPPORTUNITY] , for example note the high volume selling in this chart of the NASDAQ composite index (QQQQ) when it experienced a bottom(s) [http://bigcharts.marketwatch.com/charts/big.chart?symb=qqqq&compidx=aaaaa%3A0&ma=0&maval=50&uf=0&lf=268435456&lf2=0&lf3=0&type=2&size=3&state=8&sid=2666326&style=320&time=8&freq=1&comp=NO%5FSYMBOL%5FCHOSEN&nosettings=1&rand=6416&mocktick=1] . The peak in volume may precede an actual bottom.

*Other signs of a market bottom:
**Decline in the number of new price lows [http://www.tradingmarkets.com/.site/community/articles/favorite_strategy/New-highs-new-lows-and-market-cycles.cfm New Highs, New Lows, and Market Cycles,By Brett Steenbarger] . Chart for Nasdaq & NYSE Composite New Lows [http://www.schaeffersresearch.com/streetools/filters/comp_nh_nl.aspx]
** Moving average convergance divergence (MACD) is used to assess longer term trends and the MACD histogram is used for shorter term trends. When the MACD line crosses over to a positive range (top half of the chart) it is a sign that the uptrend has resumed. For example the MACD of the QQQQ at a market bottom might look something like this chart. [http://bigcharts.marketwatch.com/charts/big.chart?symb=qqqq&compidx=aaaaa%3A0&ma=0&maval=9&uf=0&lf=4&lf2=0&lf3=268435456&type=2&size=2&state=8&sid=2666326&style=320&time=8&freq=1&comp=NO%5FSYMBOL%5FCHOSEN&nosettings=1&rand=8836&mocktick=1]
** Very high volatility as measured by the volatility index VIX or VXO [https://www.donfishback.com/blog/2008/07/11/vxo-spikes-past-32-vix-drifts-up-to-29/ VXO Spikes Past 32 - VIX Drifts Up To 29] . A VXO reading above 30 that creates a sharp one or two day peak on a chart is often indicative of a market bottom [http://finance.yahoo.com/q/ta?s=%5EGSPC&t=1y&l=on&z=m&q=l&p=m50&a=m26-12-9,vm&c=%5Evxo Yahoo Plot] .
*Chart patterns: A bottom is often seen as a long term price pattern within a chart. Some of the more common chart patterns used to evaluate a potential bottom reversal of a stock or the stock market in general are:
**Inverted Head and shoulders, double bottom (a W-shaped formation), triple bottom, or cup and handle patterns.
**Japanese Candlestick patterns: Abandoned baby bull, Morning star bull or Morning Doji star pattern [http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:candlesticks_and_sup Candlesticks and Support] .

Risks of attempting to invest at a market bottom

It is very difficult to identify the exact day(s) during which a market bottom is reached. Investing at the time of a perceived bottom can be quite risky, and is often compared to catching a falling knife [http://www.fool.com/investing/value/2007/05/29/how-to-catch-a-falling-knife.aspx How to Catch a Falling Knife By Richard Gibbons May 29, 2007] . In this kind of a situation many investment advisors recommend that an investor proceed with extreme caution and:

* Carefully assess the current and future outlook of the market.
* Invest only when the market and its component stocks are grossly undervalued.
* Make an investment/purchase in three sections, instead of one single purchase.

Examples of investors who incorrectly guessed a market bottom during the period of Oct. 30, 1929-Oct 31, 1931 (see Wall Street Crash of 1929) are given at [http://www.gold-eagle.com/editorials_01/seymour062001.html 1927-1933 Chart of Pompous Prognosticators] Note that the average P/E (price to earnings) ratio of S&P Composite stocks was 32.6 in September 1929 clearly above historical norms.

2008 market drop

The sharp stock market drop during early October 2008 has resulted in significant disagreement about the nearness of a bottom [http://online.barrons.com/article/SB122342016780613047.html?mod=googlenews_barrons When Market Analysis Capitulates, By MICHAEL KAHN ] . The Chicago Board Options Exchange volatility index (VIX) reached levels never seen before (76.94 on Oct 10), and a large number of new lows have also been observed. However the massive volume that indicates a capitulation had not yet been observed [http://www.istockanalyst.com/article/viewarticle+articleid_2691073.html Without Capitulation Volume We Can Just Keep Selling Off] (until possibly Oct 10, 2008).

Oct 2008 S&P 500 Drop
DateIndex Change Volume
10-Oct-08-1.2%11,456,230,400
9-Oct-08-7.6%6,819,000,000
8-Oct-08-1.1%8,716,329,600
7-Oct-08-5.7%7,069,209,600
6-Oct-08-3.9%7,956,020,000
3-Oct-08-1.4%6,716,120,000
2-Oct-08-4.0%6,285,640,000
1-Oct-08-0.3%5,782,130,000
30-Sep-085.3%4,937,680,000
29-Sep-08-8.8%7,305,060,000

Jim Cramer, founder and owner of TheStreet.com and host of the CNBC show "Mad Money", expressed his view on October 7, 2008 that "we are nowhere near a bottom" [http://www.thestreet.com/story/10441178/1/cramers-mad-money-recap-oct-7.html?puc=googlen&cm_ven=GOOGLEN&cm_cat=FREE&cm_ite=NACramer's 'Mad Money' Rec
] He said that "three things that need to happen before a bottom in tech can occur. First, the earnings estimates for these companies need to be cut repeatedly until the companies can beat them. Second, companies with bulging inventories need to work through those inventories. And finally, the economy needs to turn around."

Ed Yardeni, of Yardeni Research stated on October 7, 2008 "I'm not sure, but that sure seemed like capitulation yesterday ... stocks are cheap, with the S&P 500 trading at a mere 10.8-times estimated earnings" [] .

The technical analyst Jeff deGraaf [http://www.cnbc.com/id/27074829 Chartology - Is The Bottom In?] stated "we’re only in about the 5th inning of the downturn." He said "The total number of new companies making 52-week lows has reached 57% .. usually when the number crosses 50% it signals a wash-out... Right now we’re 250 days into the bear market. Typically a bear market runs about 600 days."

Mark Hulbert on Oct. 7, 2008 pointed out that the Hulbert Stock Newsletter Sentiment Index (HSNSI), as of Monday evening, stood at minus 33.5%. As of immediate past Friday's close, in contrast, the HSNSI stood at minus 36.1%. This slight rise suggests that capitulation has not yet occurred [http://finance.groups.yahoo.com/group/mutual_funds/message/1762 Capitulation watch continues in vain] .

Vanguard Group founder John Bogle [http://www.cnbc.com//id/27083747 Stock Selloff May Be More Than Halfway Over: Bogle] stated on Oct. 8 2008, that "the stock market bloodbath is probably more than halfway over".

In an interview at night on Oct. 9 2008, Jeremy Siegel expressed the view that if libor rate goes down to 2%-1.5%, it will result in a hugh rally. He suggested a turnaround in the afternoon of 10 Oct 2008 is possible, although one can never be certain [http://www.cnbc.com/id/15840232?video=884250230&play=1 Time To Go Shopping?] .

Blackrock Vice Chairman Robert Doll said on early morning of 10 Oct 2008 "Often you see double, triple normal volume and we've just not seen that kind of capitulation yet" [http://www.cnbc.com/id/27113130/ Nobody Knows Where Bottom Is: Blackrock's Doll, By CNBC.com | 10 Oct 2008 | 07:43 AM ET] . However later on 10 Oct 2008 high volume was reported. "Nearly 1.1 billion shares trading hands by midday, close to half of what most experts consider enough for capitulation." [http://www.cnbc.com/id/27114456 Higher Volume Indicates Push Toward Turning Point, Jeff Cox, CNBC.com | 10 Oct 2008 | 01:09 PM ET]

ee also

* Market Trends
* Technical analysis
* Market timing
* Stock market cycles
* Recession

References


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