Friday, October 17, 2008

Stock Market Bottoms

Lately it seems like every other day there is a list of "experts" on television calling another market bottom. There is one pattern that seems to occur that is worth committing capital to. It gives a defined stop area and in more times that not, gives a great risk reward ratio. An example of this pattern is shown in the chart below of the S&P 500 Index from 1974.

S&P 500 Index 1974 (click to enlarge)

The pattern in 1974 shows the market making a strong move down. This is followed by a bounce re-tracement that is more than a few days. The time frame of this bounce usually has a relationship to the time frame of the sell off. If the sell off is over a few weeks, a bottom pattern is not going to be made in a day or two. It is going to take time to form. It is important to follow the price and volume after the bounce and the market trades down trying to make a new low. If the previous low is the bottom, the second move down will have less momentum and less volume, and usually fall short of making a new low, as in the end of 1974.

Another example can be seen in the chart below from 1990. The sell off is not as dramatic and the recovery matches the "personality" of the sell off.

S&P 500 Index 1990 (click to enlarge)

In 1998 the market had a dramatic sell off the resulted in a pattern that is different than the two above. In this example as the market traded back down to the previous low, it made a new intra-day low but the close of the day was higher that the previous low close. It is important to watch volume on this type of day. Once the price on this second new low recovers and passes above the previous low, buying and short covering will usually propel the market higher with strong short term momentum. When the hope of new buyers wanting to have the market go higher is joined with the realization by short sellers that the low is most likely in place, a strong up move can follow. It isn't always worth chasing this move if you miss it. Wait for a pull back.

S&P 500 Index 1998 (click to enlarge)

S&P 500 Index Now (click to enlarge)

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