All the ideas presented here-forth are not my own, they come straight out of Jim Cramer's book "Real Money - Sane Investing in an Insane World" and he gets all the credit for these ideas... I'm simply posting them here for a good future reference so please don't sue me Mr. Cramer :)
This does not focus on spotting the occasional bottom, but the "Mega Bottom" - that very rare but very profitable bottom that signals a major low. Once the market begins moving up from a Mega Bottom, it will continue to move up for several years to come.
Spotting a Bottom in the Market
1) Market Sentiment
Use the following checklist to determine market sentiment. It is only a sure-fire "Mega Bottom" if all of the following items are met:
- Pain. You know you're at or near a bottom when the pain of the current market becomes so great, that news of the market's woes makes the FRONT PAGE of the New York Times. At this point, the pain has become so great that it has permeated every facet of our society.
- Investor Intelligence Survey of Money Managers. This can be found in every Thursday's edition of Investor's Business Daily. Once the percentage of Bulls has dropped below 40% (or the percentage of Bears has risen above 60%) you have satisfied this condition.
- Mutual Fund Withdrawals. Leading up to the bottom and for part of the bottom, you will see Mutual Funds withdrawing massive amounts of money from the market. You will see these withdrawals for tax purposes occasionally, but any multi-month sustained period of withdrawals is a sure sign a bottom is here or near. These numbers are available in most Saturday and Monday papers after being released by AMG.
- VIX (Volatility Index). The VIX is a measure of put to call ratio that indicates either complacency or panic in the markets. Any reading at 40 or above indicates a sure fire Mega Bottom. Typically, the 3rd week of a 40+ reading is the safest time to buy in a bottom.
- S&P Short Range Oscillator. This oscillator is a stochastic, meaning it indicates conditions of "overbought" or "oversold". The middle of the oscillator, a value of "50" indicates perfect equilibrium. This condition is satisfied when an extreme oversold period has been reached. All major bottoms have given a reading of -7, or 43 on the oscillator. The formula for the oscillator is: ((High - Open) + (Close - Low)) / (2 * (High - Low))
2) Capitulation
Ever major bottom begins with what's called a "crescendo sell off". In this sell off, several participants who have continued to hold on to their stock despite a rough period "can't take it anymore" and the "pain becomes too great." This sell off is, basically, where a massive number of sellers converge to sell stocks down FAR below where the fundamentals say they should be. Crescendo Sell Off's will have the following indicators:
- Dramatic Imbalance Between Lows and Highs. You will have anywhere from 400 to 700 new lows being hit, and only a hand full of new highs.
- Brokerages Force Selling on Marginal Players. During these periods, brokerage houses will actually "force sell" positions that their marginally invested customers hold. This is because of a rule stating "unless the customer borrowing from the firm puts up more equity when positions go against him to the point where his collateral no longer meets the requirements, the positions must be cashed out." Basically, people buy stock on margin, and as the value of the stock goes down without the customer supplying more equity to the broker, the broker force-sells the stock to cut their own losses. This tell-tale selling will often occur between the hours of 1:30 PM and 2:30 PM on trading days. On down days, between 1:30 and 2:30, you will see massive amounts of selling in the markets. You can tell you're reaching or have reached the bottom when this selling between 1:30 and 2:30 dries up on down days. Keep in mind, this selling WILL ONLY OCCUR ON DOWN DAYS.
- Massive Spike in Volume. You will see day after day of low volume, lethargic selling. Then, as though out of nowhere, you will see volume dramatically spike. This is an indicator that not only are institutions unloading massive amounts of their shares at discounted levels, but institutions are also buying massive amounts of those discounted shares.
- Underwriting Dries Up. Brokerage houses make a good deal of money off underwriting. As a market declines, they often get stuck with "excessive inventory" as a result of underwriting. When underwriting completely dries up, this means the bottom is just a month or two away.
- Order Imbalances. This is when the market as a whole is opening the day with a dramatic decline. All Mega Bottoms will have at least a couple of days (but not weeks or months) of this kind of behavior. Order Imbalances with no news to support them are a sure sign that selling has hit a fever pitch, and panicky market participants are being flushed out.
3) Catalyst
An event will occur that triggers an "exquisite moment" - the moment where you have to buy because the opportunity is so great. The goal here, however, isn't to pick the exact event that sparks the rally. The goal is to use steps 1 and 2 to know that some sort of catalyst will hit soon and ignite a blaze. Examples of past catalysts: 1991 and 2003 we went to war with Iraq; 1998 and 1987 the Fed took "surprise" action to increase liquidity in the markets.
Spotting a Bottom in a Specific Stock
Once you have spotted a Market bottom, you may then proceed to spot the bottom on a specific stock. Keep in mind, though, that the vast majority of stocks will bottom around the same time the Market bottoms.
Keep in mind that while spotting the bottom of a specific stock, you want to avoid stocks with a lot of debt. Debt-laden stocks have a greater chance of actually going to 0 (thus being worthless) than stocks with little or no debt.
Also keep in mind that the following is NOT a check list - simply a list of ways that you can tell if a bottom has occurred on a specific stock.
1) Loss of Sponsorship
When a stock has lost most or all of its support on Wall Street, this is a good sign it has bottomed. Stocks near their bottoms will receive multiple downgrades, and will have more "sell" recommendations than "buy" recommendations. This is because stock analysts focus almost exclusively on earnings numbers when making their recommendations. If a stock "misses" on earnings, no matter how temporarily or how much, the stock will be downgraded and will have "sell" recommendations slapped on it. If a stock has great fundamentals, and little to no Wall Street support, this is an excellent time for you to buy!
2) Bad News Has No Effect
Most bottoms get formed only when all the sellers have finished with a stock. At this point, no one remains who is affected by negative news... and no one remains who will have a knee-jerk reaction to sell on negative news. If you see negative news hit a stock, and it either stays the same (or in some cases, goes up!) then the sell off on that stock has ended.
3) Consistent, Large Insider Buying
Company "insiders" buy for one reason: to make money. They will sometimes attempt to "bait" investors in by making small buys. DO NOT LET THIS FOOL YOU. Only widespread purchases in the millions of dollars will let you know for sure. You will need to see multiple people buying too, because there's always "that one guy" with extra money to throw around.
4) Negative Rumors Have No Effect
Different from news, rumors have no actual basis in fact. It is common for large institutional firms to spread negative news about companies to force prices lower. If, however, a negative rumor hits a stock and it either stays the same or goes higher, then it has bottomed.
5) Macro Economic Policy Cycles
Our macro economy has varying cycles that tie directly to Fed policies and the stock market in general. For example, if the Fed tightens monetary policy this tends to cause fear that cyclical companies (retailers, auto's, etc) won't fair as well. When this tightening occurs, most people will flock to your "Kitchen, Bath, Medicine Cabinet" stocks such as Proctor & Gamble, Coke, or Kellogg's (meaning you can spot bottoms in these sectors). As the fed continues to tighten, different sectors will hit tops & bottoms until the cycle is completely reversed on the Fed's first easing of monetary policy.
6) Tax Sell Off Bottom
The end of the fiscal year for Mutual Funds comes at the end of October. Because of this, they must sell off their "losers" for tax purposes by the end of October. You will often times see a mid-to-late October drop off (or in the case of an extreme Tax Sell Off, a crash!). This is also the reason why most major market melt downs happen in the month of October.
