The past few trading days have been a nice change of scenery haven’t they? I haven’t made it a secret that I’m not sold on the idea that we’ve put in an absolute bottom in equities just yet. With that, I’ve been asked a few times what I look for then in a market bottom.
Before going into each point, it’s important to note that predicting or calling a market bottom is not critical to a traders success, far from it. Sticking to your risk management principles and taking trades that fit your strategy are more important than being ‘that guy’ who called the tops and bottoms to the S&P or Nasdaq. The underlying purpose of measuring the health of an uptrend or downtrend (in this case) is to help get an idea of how much risk is built into the market for either direction. I subscribe to the idea that capital markets are one big rubber band, once that rubber band has been stretched to its maximum resistance it will likely revert to its mean. It’s just a matter of finding the optimal time during that ‘stretching’ to determine if the risk is warranted to begin stepping back into the market.
So with that, below are a few of the things that I look for to gain confidence that a bottom has been put in for equity prices or at least that some of the risk may have diminished from adding equities to the watch list.
1. Momentum divergence. Normally we don’t see equity indices drop and then put in a bottom before creating a lower low. Seeing how momentum reacts after a retracement while testing or setting new lows can be very helpful in determining the phase of a drop in price. At a market bottom I like to see momentum diverge from price by not continuing its decent to a lower low alongside the index. This tells us that sellers might have run out of powder and an advance or period of consolidation could be in the works.
2. “Risk on” sector confirmation. Just like momentum I like to see ‘risk on’ assets begin to consolidate, taking a breather from their decline. Typically during a drop in equities we see traders shift out of ‘risk on’ sectors like technology and financials and into lower-beta sectors like utilities and health care. At a bottom I try to observe high beta sectors slow their decline in relation to low beta sectors. I’ve found looking at a ratio between the two can be helpful.
3. Bears everywhere you look. Sentiment can be very useful at market troughs. We can look at AAII or Investor Intelligence data to get an idea of investor sentiment towards stocks. We can also apply analysis to COT data to see how traders are positioned, the Volatility Index to determine how much ‘fear’ has been built into prices, and see what varies magazines are putting on their covers. If Us Weekly is discussing the drop in equities rather than Lindsay Lohan being arrested again, there’s a good chance the market’s teeter-totter has become unbalanced towards sellers.
4. Volume confirmation. As mentioned above, markets typically don’t a bottom in a single drop. When/if a lower low is put in we can take a look at total volume to see if it’s rising or falling. If volume is decreasing alongside equity prices then we can assume there are fewer sellers entering the market. However, other factors need to be taken into consideration, for example this week historically experiences lighter than normal trade volume due to the Thanksgiving Holiday.
These four points are far from a Holy Grail to stock trading. These are just a few examples of some of the market relationships I look at when equity prices are in a decline. It’s my opinion we are in the ‘retracement’ phase of a market decline but I’d be happy to be proven wrong. I don’t marry my opinions and am content to shift my view when the market proves me wrong.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+.