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Spotting Market Bottoms

Spotting Market Bottoms
April 16
23:35 2012

When things are going badly, it’s human nature to wonder when they’re going to get better. For a trader it’s even more important, because when stocks just seem to keep going down and down day after day, knowing when the bottom has truly occurred is crucial. While bottoms represent great buying opportunities, they also represent a costly trap if you buy in before the bottom has been reached. For the bear market trader, knowing when to exit short positions is equally important.

Here we’ll examine some methods of spotting approaching market bottoms. To clarify, these apply to the overall market, not to individual stocks—those should be traded based on your normal analytical practices.

Market bottoms come in various shapes, but for relatively V-shaped bottoms, a second, shallower bottom is a good indicator. (This is, of course, by necessity a trailing indicator.) If the market hits a low, rebounds, and then falls again but to a higher low, the chances are good that the prior low was the bottom. This is in essence the second half of an Elliott wave, only inverted, with an a-b-c bottom-rebound-lower bottom pattern continuing into a longer-term uptrend.

Typically in a protracted downturn, bullish patterns will nearly disappear from the market. Once the bottom occurs, bullish patterns will start to reappear, but early on most will fail, heading down again or trending sideways. While this pattern frequency will not tell you the duration of the bottom, it does serve as an indicator that a bottom is forming and will at some point reverse.

The frequency of stock downgrades is another indicator. In a bear market, almost two-thirds (between 58% and 62%) of downgrades have historically occurred within a third of the 52-week market low. If you see downgrade frequency picking up, this is normally a leading indicator (roughly a month ahead) that the market bottom is approaching.

Volume is a handy signal, just as it often is with individual stocks. High volume represents strong market sentiment, because while substantial price swings can occur (in either an index or an individual stock) on low volume, strong volume means a substantial percentage of traders share the prevailing sentiment. As a market bottom approaches, many investors will be exiting positions, contributing to downward movement on high volume. Let the panic selling work itself out, and then start watching for the reversal.

You should also watch the market reactions to significant economic news, both good and bad. If bad news comes out and the markets barely flinch, it is a sign that pessimism is already factored into stock prices. In some cases the markets may even advance slightly, which is a sign that some factor other than bad news is now driving prices. Conversely, if the markets rise on news that is even slightly good, it is a sign that the markets are oversold and looking for an excuse to advance. In other words, selling pressure is almost gone, and a bottom has occurred or is very near.

Finally, one purely technical indicator is the prevalence of pipe bottoms. A pipe bottom is two (on rare occasions more) successive trading weeks in which a stock sees unusually high trading ranges with sideway price movement, and will appear as two long candlesticks that overlap substantially. (Remember to look at a weekly, not daily, chart for pipe bottoms.) Pipe bottoms are normally uncommon, and you may find only a handful (that is, less than ten). If that number spikes to three or four times its usual frequency, it is often a sign that the market is about to bottom. They show up before an initial bottom, which will normally be followed by a bounce and then a second bottom—which is the true one.

Predicting major market bottoms is no mean feat, and can sometimes be akin to guessing when winter’s last frost will occur, but using multiple factors to identify bottoms is your best means of making an accurate evaluation.

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