Thursday, October 16, 2008

Will We Know When We've Made A Low?

At some point, this stock market is going to overshoot to the downside, just as it overshot to the upside, and there will be tremendous money to be made. Of course, everyone wants to catch the bottom, so that creates violent rallies when it seems as though we've made a low and equally violent reversals when those hopes are dashed.

A look at some recent large market declines--1970, 1974, 1987, and 2002/2003 (charts above)--suggests that market bottoms following major drops tend to be complex affairs. Sometimes, as in 1970 and 1987, you get a washout selloff that marks intraday lows for the bear move, followed by retests that hold above that intraday low. Other times, as in 1974 and 2002/2003, you get the classic pattern of a momentum low (the point at which the number of stocks making fresh annual new lows hits a peak) followed by subsequent price lows on lower momentum (and fewer new lows).

Note how, in the charts above, there tend to be substantial rallies and sizable selloffs even after price lows have been made. This volatile choppiness makes it difficult for traders and investors to hold positions with conviction.

It is this tendency toward complex bottoms that means that investors can find good points for entry even after ultimate lows have been made. Indeed, traders who were too eager to catch market bottoms in early May, 1970; September, 1974; early October, 1987; and July, 2002 found themselves facing significant further declines. We really only know when we've made a low when we're able to assess subsequent buying interest after price and momentum lows have been made. That often means missing exact price lows, but it also avoids the discomfort of catching those proverbial falling knives.


The Stock Speculator said...

Brett - has a study ever been done on why so many people have to try and buy or call the bottom? Anytime there is a rally, you immediately hear the bottom calling. I find it amazingly odd.

stockkeen said...

Dear Brett,
I highly appreciate your post which gives insights to the bottom formation possiblities when the markets are highly volatile and investor confidence at the lowest point.With the VIX at 70+ and treasury yields at its lowest levels,the fear is at its peak in investors mind and are running for cover, it is imminent that a meaningful bounce is not far away.


pej said...

Agreed that it's going to be a very difficult exercise to catch the bottom. But I don't think it should be the current focus, unless you mean a short term bottom. In which case it's even more difficult, since you not only have to catch the current short term bottom but also the following short-term top, since the markets are still way over-valued in historical terms (see my blog: US indices update

Brett Steenbarger, Ph.D. said...

Hi Stock Speculator,

Great question. The need to be right sometimes trumps the need to make good trading and investment decisions.