SPOTTING A MARKET BOTTOM
Stock market
bottoms can be challenging to spot. And many times, investors think that they
have found this point, only for the major averages to head even lower. The big
question many have is: just how do you know when a market bottom has taken
place? This requires the tools and indicators that have identified major market
bottoms in the past, and an understanding of what they are, how they work and
that each indicator must correlate a similar reading.
Stock Market
Bottoms
Since the end of
World War II, stock prices have generally bottomed six months into a recession.
Once it becomes official that the country is in a recession, it is generally a
rearview mirror indicator meaning that there have already been two or more
quarters of negative GDP growth. On the other hand, when we are emerging out of
a recession, we will not know until many months later. This is one of the
reasons that it can be so confusing for investors to spot major bottoms taking
place. (Learn more about taking advantage of an unstable market, read Profiting
from Panic Selling.)
Things to Watch
for
Just imagine how
wonderful it would have been to buy stocks at bargain prices before major
upward moves, such as January, 1975, August, 1982, or even March, 2003. All of those periods share some
common patterns that should be observed in order to determine if the market is
bottoming.
The Double
Bottom Pattern
The double
bottom pattern is considered to be one of the most reliable of all the
technical patterns. In this pattern, the major market averages will hit a low
on heavy volume, then bounce back up and then retest the previous low on light
volume.
The key is to
watch and see how the averages trade when approaching that second low point. If
the averages have a sizable break below the previous low, it is advisable to
watch and see what happens. However, if the averages test that low point and
then have some type of reversal, this could be a sign that a double bottom
pattern is forming.
A second area to
watch is volume. This is the total amount of buying and selling that is
occurring. Generally, heavy volume on up or down moves shows strong conviction
from either the buyers or sellers. When you see the volume lighten up on the
downward moves and increase substantially on the upward moves, there is a large
amount of buying taking place. After a major market bottom has occurred, you
will see this heavy volume accompanied by a strong upward move in the major
market averages.
Economic Numbers
Generally, the
stock market will bottom and start moving higher before you see it represented
in economic numbers or headlines. In many cases, the more negative economic
news headlines you see, the better. When the press represents the psychology of
the moment, and we start to see consistent headlines showing how bad the
economy is, it suggests that the sentiment of the crowd has become so negative
that the vast majority have already moved out of their positions.
A second number
to pay attention to is the consumer confidence index. During and after market
bottoms have occurred, you will see consumer spending and consumer confidence
increase. When this happens, consumers are spending more money and corporate
earnings are starting to rise. A third economic number to watch is purchasing managers'
index, which measures the economic health of the manufacturing sector. When
these two numbers have bottomed, then started to consistently rise for more
than three months in a row, the manufacturing and service sectors are on the
road to expansion once again. (For further reading, see Economic Indicators for
the Do-It-Yourself Investor.)
High Yield Bonds
Another
indicator to watch is the high yield bond spread. High yield bonds are the
bonds issued by companies who have a high possibility of default. To be able to
attract investors to loan them money, they have to offer a higher interest
rate. When lending standards are becoming easier, you will see the amount of
interest or the spreads on these bonds drop. When this happens, it is a sign
that investors and banks are becoming more willing to take risk. This would
signal that economic conditions are starting to improve. (For more, see Top 6 Uses for Bonds.)
Copper Prices
Copper prices
are a good indicator as to how strong or weak the global economy is. This metal
is used in economic expansion in products such as pipes, radiators, air
conditioners, electronics and computers, to name a few. Watching to see if the
price of copper has bottomed or has room to fall further will help determine
the overall worldwide demand for the metal. When demand has increased, you will
start to see prices rise; when demand is falling, prices will follow.
Look for copper
prices to finish declining and start to move in a similar upward pattern with
the financial markets. This would be a real-time signal that manufacturers and
home builders are seeing their businesses pick up. To keep up with the
increases in demand, they have to use more copper, causing the price to rise.
(For more, see Guard Your Portfolio with Defensive Stocks.)
The Bottom Line
Market bottoms
are accompanied by a variety of factors, such as high amounts of fear, a
decrease in the volume on downward moves, a large increase in the volume on
upward moves, double bottom patterns, improving economic numbers, the spread on
high yield bonds narrowing and an increase in copper prices. However, it is
important to remember that the financial markets look forward at least six
months prior to any real improvement in the economic numbers. By using all of
the indicators together, you have the key to spotting a market bottom.
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