Four Commonsense Clues to a Genuine Market Bottom

by: Gennady Favel November 18, 2008 | about stocks: DIA / IVV / QQQQ / SPY    

Gennady Favel

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Financial literature and "how to" books about the market are filled with anecdotal advice on catching market bottoms.  And who can blame them.  Investing at or close to a bottom and realizing maximum returns from a sustainable bull market is the eureka scenario for any investor.

A lot of bottom-catching advice is contrarian in nature and goes something like this: If The New York Times declares that a full fledge bear market is upon us, that means that the bottom has been reached.  Or if your aunt Judy has thrown in the towel and liquidated her 401K and mutual funds, it is now time to buy since aunt Judy represents the panic and misunderstanding of the market by the common people.

Other more technical strategies look for certain chart patterns like the reverse head and shoulders, a moving average cross, or the upside-down flounder (I made the last one up.)

The fact is that in this most recent market sell-off, we saw these "buy signals" at Dow 11,000, Dow 10,000 and Dow 9,000, and here we are at Dow 8,000.

I propose a different approach.  Instead of reading tea leaves or trying to measure aunt Judy's blood pressure for signs of a market bottom, we use a heuristic approach to try and figure out when the market might be close to bottoming:

1. Energy Prices.  We may recall that in the beginning of 2008 one of the reasons for the market's poor performance were the soaring energy prices.  When oil crossed the $100 per barrel mark, market indexes became negatively correlated to the price of oil.  It is reasonable to assume that as energy prices continue to slide down, a sustainable bottom will be reached, at least for sectors that rely heavily on petroleum products.

2. Stock Prices Start Reaching Book Value.  A good indication of a real market bottom is when market prices start to reach book value levels ('assets minus liabilities').  At this point it is likely that we will see buyout firms try to take advantage of the situation and buy companies or take them private.  An increase in M&A activity and buyouts would certainly indicate that investors are ready to commit large amounts of money to the market.

3. Unemployment Levels Stabilize.  Let's face it, the retail investor will not invest his savings and 401K plan into the market if he feels that his job is not secure and he might need access to quick cash.  In order to get the retail investor back into the market, the fear of job loss has to subside.  I certainly don't see that happening in the next six months.

4. Composition Changes in the Market Indexes.  As I wrote in my book The Stock Market Philosopher, an index that goes down is not the same index that goes up.  By looking at the NASDAQ over the past eight years we can clearly see that many of the companies that were part of the index during the bursting internet bubble went bankrupt or got delisted from the NASDAQ following poor performance.  When the NASDAQ recovered it was partially due to the inclusion of healthy new companies such as Google (GOOG) and Baidu.com (BIDU).  It may seem that a rebalance of the index holdings should have nothing to do with the health of the economy, but it has certainly worked that way in the past and I will look to big changes in the make up of the S&P 500 and the Dow to signify a bottom in the index prices.

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This article has 52 comments:

  •  
    Nov 18 02:48 PM
    Oil's rise and the market fall did not have anything to do with each other and history shows that. For a time in the fall they did move counter, but oil was used as an excuse by writers who didn't know what else to blame for the day to day movements. Correlations change. Look at gold. It used to move with oil and now it's moving in lockstep with the dow. Silver and gold were in step before and now they diverge all the time.
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  •  
    Nov 18 03:15 PM
    You used the word "heuristic". You must know what you're talking about.

    Actually, you did a good job with the heuristic part: since no one can reliably predict a "market bottom", let's give ourselves other puzzles to informally solve that may or may not be indicative of a market bottom.

    None of the above points (despite being numbered) come any closer to being "solvable":

    1. When do we declare an energy price bottom?
    2. Well, okay, maybe this point is closest to being correct, but how many (and which) companies continue below book value, and go bankrupt?
    3. After how many drops in employment levels, as in the market, do we consider employment "stabilized"...
    4. This is actually a good point, too, but again, which companies will be proven to be "healthy"? Changing the indices still depends on reading the tea leaves to get the "right" companies.

    Nice concise little use of webspace, and good thinking-outside-the-b... I don't think anyone, however, will bring us much closer to figuring out when our recession/depression will reverse....
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  •  
    Nov 18 03:18 PM
    I'm waiting for the bow-legged camel formation before I commit.
    Reply | Link to Comment
  •  
    Nov 18 03:50 PM
    The bottom is nowhere close, when you go to financial web-sites and "predicting the bottom' articles still flourish.
    Reply | Link to Comment
  •  
    Nov 18 04:30 PM
    Sean M,

    Take a look at Jeff Rubin's (CIBC World Markets) report that attempts to provide hard evidence that each major economic downturn this century was immediately preceded by a spike in oil prices. Note that I'm not saying that *I* believe that this is the case, I'm just pointing out a potential body of evidence that argues the point counter to yours. Make up your own mind. Here's the link to the report:

    research.cibcwm.com/ec...

    The chart/data that I'm citing is found at the bottom of page 4.
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  •  
    Nov 18 05:47 PM
    Gennady, thanks for a thoughtful article on this tricky subject. The vast majority of the bottom calls we have been plagued with over the last few months offer no real method behind the call, other than the old saw that the market is oversold, and therefore can go no lower. This rubbish has resulted in much loss of coin.

    At least, you have put some effort and discipline into your approach!

    That said, it is my opinion that we make a mistake when we attempt to view a true bear market bottom as a singular event rather than a PROCESS of price/time.

    The so-called bottom of 2002-2003 spanned the better part of 5 months as I recollect!
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  •  
    Nov 18 05:50 PM
    One question, one comment re: #2...

    Are you measuring this by net book value, or net tangible assets?

    And, regardless, part of the bottoming process is that there will be companies you could make a lot of money taking private, but that won't happen because of the lack of credit. Eventually the values will build up, the system will delever, and then value vultures will step in and create a bottom.

    At least, that's how I see it...
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  •  
    Nov 18 05:51 PM
    The market found a bottom and began a sustained rally in Q1 2003 after profits, which had crashed 50% in the downturn, bottomed and began to rise.

    I suspect the market will not begin to make a sustained rally at least until earnings start to rise again.
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  •  
    Nov 18 06:19 PM
    Not a bad list. I don't necessarily agree with book value, as someone who has analyzed in detail thousands of financial statements, this is a broad market thing but anyone who has mae a lot of acquisitions (i.e.) has a lot of goodwill, capitalized this and that etc and you can writeoff book value and ride it all the way down. That is really a case by case analysis. Given how high valuations have been its nice to at least see people thinking about absolute valuations in general - but free cash flow is usually the beter way to go IMHO - and this is definitely one of those times.

    The aunt judy contrarian signals i really agree with - and we aren't close to being there yet. All the expert (ie dumb) financial planners on TV are telling boomers to wait it out. The market still has a world of pain to inflict on this aging herd who are still confident they have a 10-20 year outlook. When the S&P hits 650 they may start puking en masse, it will be time to start paying attention. Once they have said "uncle" i'm in.

    The one thing you have to think about - is that this economic situation will be a drawing line between the haves and have nots - and i'm speaking of debt. So in a sense there will be two "equity markets" to think about going forward. We have not seen debt like this - personal, corporate, government - and it is possible the bottom may not look like what we are used to seeing. I've dealt with LBO financing a lot and the one thing i will say is that it takes a long time once you are full on debt and start to have stuff blowing up around you, to get that down takes a long time and your competitors start leaving you in the dust if not smelling blood and starting an all out assault. A list of the nonbank S&P 500 who have debt to cash flow under and over 3.0 or so and no near term refinancing issues -now that would be a good index to track.

    We haven't even started with stories about potential problems with China funding our gov't bailout sprees, war debt and trade deficits. No one is even thinking about inflation yet - but are printing money like its free.

    Seems to me we still have a lot of mental baggage to work through and haven't even booked an appointment with the shrink yet. If I would corrolate to the Kubler Ross scale en.wikipedia.org/wiki/..., i'd have to say john q public is nearing def con 3.
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  •  
    Nov 18 06:23 PM
    I don't think earnings are done falling. Except HP if you believe them.
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  •  
    Nov 18 06:42 PM
    As the sage and gentlemanly investor Julius Westheimer stated to Louis Rukeyser when ask when was the proper time to buy stocks said, “Buy when you have the money Lou!” Attempting to update Julius’ advice, “Buy when you have the money and the likelihood of the market doubling exceeds the probability of a 50% decline.”

    Yes, it is possible for the market to decline 50% from today’s level but interestingly, I cannot find a Vegas or elsewhere book willing to take the bet! “You betcha!”
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  •  
    Nov 18 07:08 PM
    Jim Rogers sees signs of a bottom:

    "There was a climax selling in October, the US markets were down 18% in a week. In history when you buy into a selling climax you always make money. Let`s see in 2, 3 years." Jim Rogers

    jimrogers-investments..../
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  •  
    Nov 18 07:45 PM
    i actually predicted the market top of oil within 5 bucks a couple months in advance. the way i call a top or bottom is when so-called 'experts' start coming up with outlandish predictions. with oil it was 200-400 dollars a barrel.....

    i think a general market bottom is near now, simply because i hear more and more 'experts' saying that we will be in a deflationary phase for a long time and oil could go to 5 (yes, FIVE) dollars....

    i am buying dips on oil etfs these days... (and commodities)... will double my money or more within 2 years the latest...
    Reply | Link to Comment
  •  
    Nov 18 07:46 PM
    I'm with you 100% on your observations and I agree that the shock of oil prices had a huge role in precipitating the decline. Simple and commonsense as you stated.
    Reply | Link to Comment
  •  
    Nov 18 08:32 PM
    points 1 and 3 are economic. i can go back in history to demonstrate that the dow does what the dow does independent of the economy.

    ah, but this time wall street was one of the causes of this economic crisis so we have an economic linking this time. but the dow will now do whatever the dow will do.

    for me, i see the real problem as less buyers. and for a multitude of reasons - i do not see these buyers coming back in their former quantities. even with good economic news, i doubt we will see a strong bull market anytime soon.
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  •  
    Nov 18 08:43 PM
    The market will bottom when nobody will try to guess when the market will bottom. Now seriously, why ask such a question when the bottom is still far away ? At this point I would not even talk about a stabilization of the markets.
    Till I don't hear that investors from Dubai bought a few billions homes in USA I will not remain confident of anything.
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  •  
    Nov 18 10:40 PM
    This is a waste of time.
    Reply | Link to Comment
  •  
    Nov 18 11:43 PM
    I think we are a long way from the bottom. I anticipate that the bottom will occur in early 2010 when the S&P is at approximately 425 points. Many false bottoms will be predicted before the actual bottom occurs and millions of investors around the world will lose a lot of money when buying what they think is the bottom only to discover later that the true bottom was much lower. In this black swan economic disaster, the bottom will occur when most of us will have more important things to think about than where the bottom is.
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  •  
    Nov 19 12:46 AM
    Point#4 is brilliant. Most people don't realize the S&P 500 is really a Momentum Trading strategy which invests primarily in stocks that have been going up, while underweighting all the garbage that crashed with the previous bubble.
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  •  
    Nov 19 01:04 AM
    Agree with Alex...#4 is a real thought provoker ,we are likely to see big changes in the Dow and the S&P makeup.

    Rest of the article is more of the same...but still worthwhile..
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  •  
    Nov 19 01:26 AM
    So many people think this is the low...so, this is almost certain to be the low. How could so many be wrong?
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  •  
    Nov 19 03:24 AM
    Cramer is the gold standard of investment advice schlock. 5 Cramers is the ultimate schlock advice. You get a 3 Cramer rating.

    3 Cramers - not bad! - congrats. You would have earned an extra Cramer if you had included some reference to "Moving averages" , "Stochastics"... or other magic.

    Employment is a lagging not a leading indicator. Once employment rises you will be +20% from bottom. Thanks for coming.

    Oil is an very indirect inficator of economic activity and mostly in emerging - energy intensive markets - has little to do with market bottoms or top.

    Market indexes - huh? That's a good one. As in "funny" good, not "good" good.

    Book value - you are kidding right

    This is really drivel even by the standards of web schlock - it is in the Cramer category.

    Stock prices are driven by earnings and value relative to other risk-free assets. Once the Earnings yield vs. US treasuries reaches the right spread threshold - stocks rise. We are probably close. Right now 2009 is nicely discounted. Maybe it will be worse - could be - if you think that - short the market - if not buy.

    Take care.


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  •  
    Nov 19 03:50 AM
    Gena might be a genius on his point #4, but I'll take his point #2 on M&A activity pick-up over any other. The predators and vultures from Private Equity, who are now saddled with mountains of debt and while their portfolio company values sinking right under their feet, will be my canary in the mine.

    Although, if a really long and deep depression hits, they (PE guys) might eventually be forced to sell their portfolio companies just to liquidate their funds, creating an uptick in that very M&A activity... But lets not think of that scenario...
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  •  
    Nov 19 05:09 AM
    If there is enough cash on the sidelines to lift all companies 10%, then the market could turn around at an instant. The money isn't ther. When debt is undercontrol, savings in banks start to rise and people feel confident to play the game again then the bottom will be here. As long as people don't have jobs or are losing pay and commissions, they will sell. They selling will be stronger in the beginning as people are letting their old habits control their spending and savings habits. As time goes by people will have no choice but to be more thrifty and save. It won't be easy for people who live in the buy-it-have-it now society. For the meantime, people will have to give up some of their possessions to sustain their old way of eating, living, and entertaining. They'll sell a little jewelry then the boat, then the unnecesary car, then the condo, or the land out in the countryside. Eventually they will change their habits. After a time they will start to invest again.

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  •  
    Nov 19 08:20 AM
    I once heard Mick Jagger of the Rolling Stones make a very profound comment.

    An interviewer back in the '60's once asked Mick if he thought the Stones had "progressed,"... (as in progressed forward as a band.) Without missing a beat, he answered, "I don't think a "progression"... really exists, because at any given time, you never know whether you are going forwards, backwards, or sideways."

    Think about it. Isn't that true?

    Today, we could ask ourselves if the market is going up, down, or sideways. The truth is no one knows where the market will be tomorrow, or the next day, or next week, or next month, etc. If we really thought we knew, we would bet everything we had on it. But, we don't make that bet because we aren't sure.

    So, has the market bottomed yet? We don't know. How can we tell? Well, the only way to really know is to look back in time and see. We can see a bottom in 1932 for the 1929 crash, and we can see bottoms in the '87 and dot com busts clear enough because we are far enough in time away from them. Those are obvious. But for this meltdown, we won't be able to see the bottom, and know it is truly the real bottom, until long after it is past. And for this mess, it will take a very long time after its past to really know.

    Don't forget, there were many "bottoms" between '29 and '32 that actually looked like the "real bottom," where the market went up 20 to 50% each time, but it wasn't until the market was down 89% from the peak, did we hit the "real bottom." We have yet to recover even once since the top last year, anywhere near 50%, yet people are wondering if we have bottomed yet. Its probably much too early, folks.

    I think its good to look at the macro view and see how everything is looking economically all over the world. The way I see it right now, it looks HORRIBLE everywhere. It also looks like things are just getting started in their melting process. Don't forget, some of the underlying causes of our problems now, have been decades in the making.

    I am all in cash except for 7% in double inverse index ETFs. My entire perception says we are going down big time from here over the next 3 to 6 mo short term, to about 2 yr long term. A lot of leverage has to unwind, and it may take awhile as governments try to create a smooth drop into a soft bottom.

    So, because we can't find the bottom until long after its taken place, mathematically speaking, the optimum way to get back into the market is to begin to buy in spurts before the bottom gets here. Probably about the time you don't think things could go any lower would be a good time to edge in maybe 10%. Then wait for that feeling again and go in another 10%, all the while keeping on top of the world wide macro conditions. Of course, there is no set way to do this, because its your EMOTIONS that will dictate how you proceed, and we all know what wonderful leading indicators they are.

    And that's the real problem, because logic, technical indicators, etc., etc., don't work in predicating the future. It may look like they worked yesterday, but that was a coincidence. Nobody can drive a car by looking in the rear view mirror. So all we have are our emotions. But that's as good as it gets, so best of luck and try to have some fun in the process.
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  •  
    Nov 19 09:54 AM
    I'll stick with my own timer as it has served me well.
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  •  
    Nov 19 09:56 AM
    At the rate the market has been diving, I would safely say that when stocks go to ZERO, we can safely assume the bear market has ended (toungue in cheek, of course).


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  •  
    Nov 19 10:09 AM
    Good article. The only problem with P/B is that if you're not sure what the liabilities are actually worth or if the company has off balance sheet liabilities not publicly disclosed than you can get into some serious trouble. Many sectors have been trading below P/B or NAV for quite some time now and while the broader market might be an indicator I think the S&P with strong financial weightings skews that result somewhat. I would caution against P/B as a valuation for a market bottom and continue to look to equities who continue to increase their book value by meaningful growth rather than growing the business through equity or debt.
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  •  
    Nov 19 10:17 AM
    Don't waste your time trying to predict bottoms/tops. If ayone knew it for sure he/she wouldn't be talking about it. Speculate - you can - but that can be done at all levels...why only bottoms?
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  •  
    Nov 19 01:14 PM
    The biggest factor by far is housing. Until housing stabilizes, banks will not lend and will continue to hoard cash. The economy will continue to deteriorate and earnings estimates will continue to be lowered across all sectors. Home prices don't need to appreciate to reverse this trend. But foreclosures and inventory have to come down significantly and prices have to flatten.
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  •  
    Nov 19 02:00 PM
    I wouldn't use #3. Unemployment is a trailing indicator. Stock prices are a leading indicator.
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  •  
    Nov 19 02:44 PM
    Whooper - stock prices don't lead a damned