How To Spot When The Market Bottoms
Investor's Business Daily - investors.com
IBD founder and Chairman Bill O’Neil constantly emphasizes that the best time to get back into the market is after a correction or bear cycle just as the market starts uptrending again. In order to do this, it is essential to be able to spot a market bottom. In this lesson, O’Neil discusses the signs to look for to detect a market bottom.
Q: Is it really important to know exactly when the market is turning up?
O’Neil: Bear markets create fear, uncertainty and a loss of confidence. When stocks hit bottom and turn up to begin the next bull market — loaded with opportunities — most people simply don’t believe it. They’re hesitant and afraid. Why? Most new investors, even professionals, are still licking their wounds. Without a system of cutting losses, or a way to interpret general market action, most people lose money and get hurt during market corrections.
Right when the next market cycle’s big new winners are marching up to the starting gate, getting ready to run the race of their lives, investors freeze up because they’re scared and because they don’t follow a system or a set of sound rules. So they rely on their emotions and personal opinions, which are totally worthless at critical turning points like a major market bottom. The market’s opinion is the only one ever worth following at this crucial time.
Q: How do you tell when the market is definitely turning up for real?
O’Neil: At some point on the way down, the indices will attempt to rebound or rally. Bear markets normally come in two or three waves, interrupted by several attempted false rallies that usually fizzle out after one, two or three weeks and occasionally five to six weeks or more.
Eventually, after almost every stock has broken down and sold off in price and enough bad news and time have passed, the market finds real support. One of these attempted rallies will finally follow through, showing real power, indicated by one of the indices (Dow, S&P 500 or Nasdaq composite) closing up 2% or more for the day, with a jump in volume from the day before.
You can’t tell much on the first or second day of a rally, with all its exuberance, so it’s best to not act upon them. The rally has yet to prove itself and still may be false. The market often settles back for a day or two, but holds above its low or support level. The rally’s support level is the lowest trading price of the first day of the rally. If it comes on again with clearly overwhelming power, you have a valid follow-through day, otherwise known as a confirmation of the turn. It usually occurs on the fourth through the seventh day of the attempted rally. Follow-throughs after the 10th day indicate the turn may be acceptable, but somewhat weaker.
I check the Dow Jones industrials, the S&P 500 and the Nasdaq composite indexes on Investor’s Business Daily’s General Market & Sectors page every day. An initial follow-through can occur on any one of the indices and is usually followed a few days later on another index. I have never missed the very beginning of a new bull market with this method of tracking the general market indexes carefully.
About 20% of the time they can give a false buy signal, which is fairly easy to recognize after a few days, because the market will usually promptly and noticeably fail on large volume.
The reason for false signals? A huge institutional investor knowing this method can run up a few of the Dow stocks, or a few big high-tech leaders in the Nasdaq, and create a false impression of a valid follow-through day, especially if the market moves up on some seemingly good news that day. However, most true follow-throughs will usually show strong positive action on good volume either the day after the follow-through or several days later. At any rate, convincing power and strength are what you want to observe.
Markets usually discount news items and look ahead of the economy — up to six months in advance. Don’t make your decisions based on your opinion of the news. Make it on the objective observation of when and how the general market indices finally change direction from their downward trend. Markets are rarely wrong; people’s opinions and fears are frequently wrong.
Q: What should investors look at first on the General Market & Sectors page?
O’Neil: I would rank day-to-day evaluation of the three key indices as the first to consider. After the Dow, S&P 500 and Nasdaq, next in importance would be observing the behavior and action of the leading stocks in the market. Are they acting normally or abnormally? Have the majority of them topped? This is really all you need, but it takes some study and experience to get it down accurately.
Of the remaining market variables, I would list changes in the Federal Reserve Board’s discount rate (or fed funds rate) next in importance. The discount rate is what it costs member banks to borrow money from the Fed. Logically, a cut in the rate encourages borrowing and increases money supply, whereas a hike in the rate does the opposite.
A lowering in the rate can generally signal a new bull market. But this indicator is not as reliable as really knowing how to interpret the market index changes. For example, two bull markets developed with no Fed rate cuts, and three times (in 1957, 1960 and 1981) the Fed lowered rates and the market continued to go down.
Q: What about the psychological indicators? Are any of these useful?
O’Neil: There are a couple of psychological indicators that gauge mass opinion about the market. These are next in importance. They are the percentage of investment advisers who are bullish or bearish and the ratio of put volume to call volume, both found on the General Market & Sectors page. These indicators are generally contrarian.
Take the put/call ratio. Stock option players buy calls in hopes that a stock will go up in price and puts if they think prices will fall. But option investors are historically wrong at key turning points about the market’s direction. When they’re extremely bearish, the put/call ratio shoots up. That’s when their excessive negativity signals a market upturn.
Q: What are some other ways to use the General Market & Sectors page?
O’Neil: During attempted rallies in a bear market, the advance/decline line (produced by taking all NYSE stocks that rise in price for the day and subtracting those that fall) can sometimes be of value, when it shows no ability to rebound when the indices try to rally.
However, IBD’s Mutual Fund Index can be used in the same way. For example, in August 1998 it hovered near its closing lows for three days while the Dow attempted to rally near its upper range, but later promptly dropped rapidly.
I do not use the advance/decline line at other times because it has frequently been known to give premature signals, way before a market’s eventual top. It also can show false weakness at some bottoms when the market is actually turning up.
There are dozens of other popular general market technical indicators that are of limited use. I’ve found them to be subject to frequent misinterpretation, faulty or just plain confusing. And the last thing you ever want to do in the market is get confused.
I stick to the few key ones mentioned above. Overbought/oversold indicators, the total number of new high prices vs. new low prices, up-down volume or on-balance volume, buying power vs. selling pressure, moving averages and trend lines are mainly a waste of time and an unneccesary distraction, based on my research and experience over the years. They could mislead you and cost you a lot of money.
Need additional motivation to learn how to correctly spot market bottoms and the next new bull market? New big winners emerge during the first 10 to 15 weeks of a new bull market. Cisco Systems emerged from a new base off the bear market bottom in 1990 and zoomed 15,500%. Franklin Resources bolted forward off the 1984 bear market and raced ahead 14,900%. Home Depot, then also an unknown new name, broke out at 20 with a price-to-earnings ratio of 58 in September 1982 and proceeded to climb 37,900%.
Wal-Mart came out of the 1980 20% market sell-off and went on to soar over 13,300%. I began buying Pic’n’Save in late 1976 and held it for 7 1/2 years and a 20-fold advance. It really got going coming off the bottom of the 1978 bear market. And another, Price Co., had a tenfold move in 3 1/2 years, right off the bottom of the 1982 bear market.
More recently, coming off the market bottom in October 1998, I bought America Online and Charles Schwab. AOL went up 456% from the pivot, or buy, point and Schwab went up 313%. You simply cannot afford to miss out on the tremendous new investment opportunities that occur when the market finally turns up and gives a valid buy signal.
The U.S. presents a never-ending cycle of entrepreneurial opportunities, so never let yourself get discouraged. If the market kicks you around and you suffer some reversals, that’s good. Study what you did wrong, learn from it, write out a better set of buy and sell rules, and don’t you ever miss the beginning of each new bull market. If you’re prepared, the opportunities of a lifetime will be right in front of your eyes when each new market cycle begins.
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