Stock market bottom

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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 spot a bottom after an upturn is well underway but it can be difficult to identify a bottom (referred to by investors as "bottom picking") while the market or stock is still in a decline. This is because an upturn is sometimes shortlived and results in continued price decline and loss of capital for the investor who bought stock 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:

• The Black Monday decline: Bottom at 1738.74 on 10/19/1987, as a result of the decline from 2722.41 on 8/25/1987 (Chart ^[1]).
• The bursting of the Dot-com bubble: A bottom of 7286.27 was reached 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 intermeduate top of 10635.25 on 3/19/2002 (Chart ^[2]).

A decline associated with the Subprime mortgage crisis starting at 14164.41 on 10/9/2007 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 a declining, "bear" market, resumed. (Chart ^[3]).

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^[4]. 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.

An investor who enters the market at a perceived bottom has concluded: ^[5]:

• 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.

Contents 1 Approaches for identifying a market bottom 2 Risk associated with picking a market bottom 3 See also 4 References

[edit] Approaches for 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^[6]. Morningstar's market valuation graph gives 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 less accurate method of market valuation is to use the company's profit and earnings P/E ratio.
  • Valueline's VLMAP (market appreciation potential) attempts to project a stocks appreciation over the next 3-5 years^[7]. Its use has been studied by Peter Bernstein and Dan Seiver, who uses it in his PAD system report^[8]. When the Valueline indicator rises above 100, it is taken to be a buy signal. This method of measurement also 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 is thought by many to be questionable^[9].

• 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 are thought to be highest when investor sentiment reaches extreme values. Indicators that measure investor sentiment may include:
  • Investor Intelligence Sentiment Index^[10], ^[11]: 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^[12]: 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)^[13]: During the March 2008 bottom this indicator gave a reading of minus 29.4%^[14]. 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 ^[15][16][17], and Short Interest/Total Market Float^[18][19]

• Market oversold indicators:
  • Relative strength index (RSI): This is a measure of a market, market sector or individual stock and its price strength as it relates to a given index or sector. It uses values between 0 and 100. When the RSI is below 30, the market or stock is considered to be oversold and has a weak relative strength. For example here is the RSI chart for NASDAQ Composite: [1]
  • Prices that are below several multiples (2 to 4) of the standard deviation from the 50-day moving average^[20]. For example here is thechart for NASDAQ Composite MA with 2% deviation [2]:
  • 'S&P oscillator' which is proprietary^[21][22], but is thought to be based on a formula^[23] originally proposed by George Angell. For a given bar, it is given by ((High - Open) + (Close - Low)) / (100*2 * (High - Low)) - 50%; market lows are supposed to be marked by -4% to -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. ^[24]. This group of investors then sells in panic or finds that their pre-set sell stops have been triggered therby automatically selling their shares of a given stock. This increase in the number of sellers causes a further increase in the speed and severity of the stock's price decline.

peaks[25], for example note the volume at QQQQ bottoms [3]. The peak in volume may precede an actual bottom.

• • Very high volatility as measured by VIX or VXO^[26]. VXO higher than 30 and peaking is often indicative of a market bottomYahoo Plot.

• Other signs of a market bottom:
  • Decline in the number of new price lows ^[27]. Chart for Nasdaq & NYSE Composite New Lows [4]
  • Moving average convergance divergence (MACD) is used to assess longer term trends and the MACD histogram is used for the shorter term. When the MACD crosses over to a positive range it is a sign that the uptrend has resumed. For example QQQQ MACD plots[5]

• Chart patterns: A bottom is often the bottom of a long term price pattern. Some of the most common patterns used to evaluate the market or a stock include:
  • Inverted Head and shoulders, double bottom (w-shaped), triple bottom, or cup and handle patterns.
  • Japanese Candlestick patterns: Abandoned baby bull, Morning star bull or Morning Doji star pattern^[28].

[edit] Risk associated with picking a market bottom

It is very difficult to identify the exact time of a market bottom. Investing during a perceived bottom can be quite risky, and is often referred to as an attmept to catch a falling knife^[29]. In these situations many investment advisors recommend that an investor:

• Carefully assess the current and future outlook of the market.
• Buy a stock in three sections, don't make one bulk purchase.
• Don't invest if market securities (stocks etc.) are still overvalued despite recent price reductions.

An example of investors incorrectly guessing a market bottom is given at ^[30] during Oct. 30, 1929-Oct 31, 1931 (see Wall Street Crash of 1929). 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.

[edit] See also

• Wave
• Technical analysis
• Market timing
• Stock market cycles
• Recession

[edit] References