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 bookThe 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.