How to identify a market bottom

How to identify a market bottom

In order to identify bottoms, a study of how previous bottoms were made is necessary.

One of the costliest mistakes that every market participant makes as a trader or as an investor in the stock markets is in trying to identify the market or stock bottom. The lethal mistake is made when a few days of fall or a pause after a fall is considered as a good time to enter. One of the biggest reason for loses has always been in trying to catch a falling knife. 

But is catching or identifying a bottom an exercise in futility? In order to catch a bottom, one needs to first know what a market bottom looks like. There is however, a small question of the timeframe or type of bottom one is looking at. Is it an intermediate bottom or one where the long term trend changes. Intermediate bottoms are generally identified using technical tools and indicators. 

Money flow and political and economic developments also play a part in making intermediate bottoms. But an indicator that has been working over the past few years is the panic selling seen in the derivative markets, especially when retail investors are forced to sell on account of margin shortfall. Markets have almost always taken off, at least for a short term post this sell-off day. Unfortunately long term bottoms are hard to identify, if not impossible. 

One should be satisfied even if they are within the vicinity of these bottoms. In order to identify bottoms, a study of how previous bottoms were made is necessary. 

When it comes to markets, fundamentals are generally a lag indicator. Market moves ahead of economic numbers and indicators. It has been recorded that since World War II, stock prices have generally bottomed six months into a recession. Markets start recovering well before economic data published, suggesting that economic indicators are or little help in identifying a market bottom. 

Economist has started developing econometric models to forecast economic growth which also used as an indicator to identify market bottoms. Apart from technical analysis and economic data, analysts also use corporate earnings to find bottoms. Most of the well-researched companies start their upward journey much before their actual numbers showing a turnaround. Periodic announcement, either quarterly or monthly make fundamentals a delayed signal. Markets take cues from other indicators which are more recent, to decide the direction. 

Other indicator smart traders also look is bond yield. In a falling equity market, historically bond yields have been high. Deteriorating economic condition makes it difficult to raise money. Corporates thus are forced to raise money at higher rates. Since corporates buy both in the long and short term markets, the yield curve plays an important role in the direction of the market. Whenever, a short term yield is higher than the longer term ones, we have markets coming off. 

Similarly, whenever the gap between short term paper and long term ones increases, indicating corporate are not willing to pay higher price for raising short term money as they have adequate liquidity, we have markets moving higher. 

Money is an input in industrial and financial sector. But in industrials, apart from money there are other raw materials that act as inputs. Tracking these inputs gives a very good indication of the changing scenario. Oil and copper prices are two such indicators that need to be tracked. Both these prices have a very high correlation to the market. The current share market’s movement worldwide is in tandem with the gyration in the oil markets. 

Tracking inputs gives us an idea on when markets have already turned. If bond yields and inputs have turned around the same time one can be assured of a bottom. Apart from these fundamental events, there are enough technical indicators that suggest a market bottom has been made or is close by. Tracking price and volume gives a good idea of the bottom. If prices continue to fall but volumes have dried up, it is an indication of exhaustion of selling. Falling prices need not be on high volume. Rarely is a long term market bottom made on high volume. Time and price deterioration is needed for the next bull market to start. 

The previous bottom in 2008-09 saw prices languishing for a good six months before they started crawling higher. Markets have a tendency to test previous markets low or keep on testing the recent lows. How the price reacts at these lows gives a strong indication of the plausible direction of the market. Many traders consider a bottom to be made if the preceding high that made the lowest low is taken off. In other words the market is no longer following a lower high and lower bottom classical formula of a bear market and might be ready for a higher high and higher bottom bull market trend. 

Last but not the least is how market reacts to news. If a stock keeps on falling despite good announcement, it is a clear indication that sellers are using every opportunity of a stock to rise to sell. But when stocks stop falling or start to react positively, it is an indication that selling has dried up. One can look at any of the above methods in their search for market bottom, but it is advisable to look at more than one method for confirmation.

Happy investing