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.