Market Bottoms

by Guy Lerner

Speaking of market timing, let’s talk about market bottoms.

My research shows that there are two types of market bottoms: 1) the complex and 2) the extremely oversold. Before getting to the analysis, let me clarify a few things. My data set is daily data of the S&P Depository Receipts (symbol: SPY) going back to 1993. To define a market bottom, I used market sentiment and my definition of the price cycle. The price cycle is the path that prices take from low to high and back to low again. A market that has the potential to bottom (thus having the price cycle reset) occurs when investor sentiment turns bearish (i.e., bull signal). Thus market bottoms — whether they be intermediate bottoms (i.e. occurring on weekly data) or of the secular/ cyclical variety (i.e., March, 2009) — occur when investors are bearish on the markets.

A complex market bottom is defined as a pattern that sees prices initially trading through a support level. Support becomes resistance, and when the resistance level is “re-captured”, then the trend is deemed to have been reversed. The market has bottomed, and prices are moving higher. An example of a complex market bottom is shown in figure 1, a daily chart of the SPY. The time period is from July/ August, 2010. The red dots over the price bars are key pivot points, which help us define the best areas of support (buying) and resistance (selling). Point 1 is a key pivot point that occurred during a time of bearish sentiment. This should have acted as support but it did not as prices gapped below this level (see red arrows on chart). This level was quickly “re-captured” at point 2, so resistance becomes support, and this support was tested at point #3. That is a complex market bottom.

Figure 1. SPY/ daily

The other type of market bottom is the extremely oversold market bottom, and this occurs when prices fall in a crescendo like fashion over a very short period of time. I have defined this as a 10% decline or greater over a period of 5 trading days. This type of bottom leads to a vicious snap back rally or “V” like bottom that in most cases establishes the bottom.

Since 1993, there have been 38 instances where investor sentiment turned bearish (i.e., bull signal). These are areas for a potential market bottom. In approximately 80% of the instances where there was a potential for a market bottom, the market (i.e., SPY) did so by carving out a complex pattern. The extremely oversold market leading to a vicious snap back was seen in about 15% of the market bottoms.

This past week the SPY declined over 10% in 5 trading days; the current snap back that we are seeing at the end of the week here could be consistent with a market bottom even though it is the rarer type of market bottom. As I will discuss in the next article, this type of bottom is more difficult to trade not only because it has occurred with fewer observations but also because there are some big risks associated with these kinds of extreme price movements.

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