Published June 22nd 2022

Daily Brief - How to recognize a Bear Bottom

A key insight in Jesse Livermore’s timeless classic - Reminiscences of a Stock operator - is to “never fight the ticker tape”. Buy in a bull market, short in a bear market. Nasdaq is down 32% from the highs, and the gloomy news gives it away: we are in a bear market. But how will you know when the bottom is in?

Yesterday’s Daily Brief spotlighted a treacherous feature of bear markets: bull traps, or fake rallies. Today, we’ll compile a list of indicators that can help you identify the real one: a checklist of key metrics that have historically marked major bottoms in equities.

It’s no longer about the Fed

Before we get to the list, it’s important to clarify one point: it’s no longer about the Fed. Or, at least it’s no longer ONLY about the Fed. Yes, markets seem to be trading in lockstep with the 10 year yield. However, rising interest rates were merely a necessary catalyst that triggered the revaluation of overpriced securities.

Once it is underway, a bear market needs to be fully resolved through exhaustion of bearish forces. A Fed pause or even dovish talk won’t help stocks except for a short breather: inflation data tell us Fed has to keep hiking.

A brief recap of bear market forces

Let’s briefly run through the mechanics of a bear market. It starts with the market peak and total complacency. People are fully invested in stocks, or are invested as far as they are going to get, and convinced that prices will keep rising forever. At some point, many investors will have invested everything they've got. Others will look at stocks and say, you know, I loved this stock when it was $300 but now it is $1200, the Fed is hiking, a war is going on, and so I'm not so keen on it anymore.

The enthusiasm for stocks begins to fade. The demand side of the equation diminishes, but the selling side begins to pick up, and that is what tends to send prices down. At market bottoms, complacency as the dominant emotion is replaced with fear and panic.

Here, however, is a key insight: to form a bottom, it’s not enough to see evidence of panic selling. You have to wait to see evidence of strong buying, as well. More on this shortly.

The checklist

Finally, the bear market bottom checklist. Like any list, it’s imperfect. Its aim is not to slavishly tie you to a set of thresholds but instead to give you the discipline to watch market price action carefully, and be patient for that perfect pitch.

  1. Duration: typical bear market duration is 10-12 months going back to 1929. We are just about halfway through a typical bear market but note that there is a wide range (pandemic bear market lasted about 1 month, dot.com bubble burst over a staggering 30 months).
  2. Peak to trough correction: over that same period, bear markets led to declines of about 36%. We are getting close with Nasdaq down 32% and S&P 500 just shy of 25%.
  3. Retest of the lows: very often (but not always - cue the pandemic bear market) equities retest the lows before we can be confident the bottom has been put in.
  4. Divergence with new constituent stock lows: by the time the indexes have bottomed, most stocks have stopped making new daily lows. Divergence between the index performance and the number of new 52-week lows for its constituent stocks is another key sign that breadth of buying is improving.
  5. 90% upside day: panic selling isn’t enough to end a bear market. As discussed earlier, a major bottom also needs a solid sign that low prices are drawing in widespread stock buying. One such indicator is 90% upside day: when 90% of the volume on a given day occurs in stocks that moved higher during the session. This must be based on closing data (full day, not intraday data).

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Daily Brief - How to recognize a Bear Bottom

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