This is an excerpt from our “Understanding Market Bottoms” report from April, 2020. Please contact email@example.com if you are interested in the full report and to gain more understanding in how we will identify when the current market has put in a bottom.
Key to note about market bottoms is that they can only be recognised in retrospect. But this doesn’t make them a quaint academic pursuit. Knowing a bear market has bottomed gives one confidence a new bull market has started. In this post, we outline some of the things we look for around a market bottom.
Formal Bear Market
In popular imagination, a bear market is when a market has declined by 20%. A formal bear market is a necessary but not sufficient condition to buy. Generally, when markets are down 20% around recession times, they will decline more. In fact, that is exactly what happened from 2000-2002 and in 2008-09. Very large price declines are an essential element setting up very cheap bargains and the best time to buy.
One reason very large declines in the stock market present great buying opportunities is that over the long run markets have been in a rising trend going back decades. Even in the protracted bear market in the 1970s, large drawdowns typically led to cheap valuations and a rebound in investor expectations. Markets generally follow the business cycle, and recessions and declines in economic activity in general last between 6-12 months.
The following chart shows that whenever markets have declined over 30% from their 3-year moving average, that has usually been a very good buying opportunity. Large deviations from trend in the stock market provides good buying and selling opportunities.
Plunge in Consumer Confidence
Howard Marks once said that cheap prices and good news rarely come together. Likewise, great buying opportunities rarely happen when everyone is upbeat and consumer confidence is high. The time to buy stocks is when consumer confidence has plummeted. However, you can extract an even better bottom and buy signal for the upturn by looking at the ratio of expectations to current conditions. When people are miserable but think things will get better in the future, that is usually the bottom of the market. As you can see, the surge in expectations/current conditions has led the S&P 500 consistently.
Contracting Manufacturing Sector
Likewise, when it comes to the economy, bad news is often good news for the market. The ISM Purchasing Managers Index from the Institute for Supply Management is based on data compiled from purchasing and supply managers nationwide. When the ISM Index shows that manufacturing is contracting (a level below 50), the economy is usually in a slowdown. If it drops below 45, the slowdown most often ends in a recession, and that generally eventually leads to a buying opportunity in the stock market.
Recession is formally declared
For the 2007-09 recession, it was formally announced by the National Bureau for Economic Research in December 2008 to be a recession. At that stage, the recession was a year old, and the stock market bottom was only three months away. The formal announcement of a recession tends to be a lagging indicator. You should be a buyer of the market when a formal recession is announced by the NBER. As you can see from the following chart, the green lines represent the end of a recession. These have almost always happened near the bottom of markets.
The NBER has been unusually prompt this time, declaring in early June the US went into a formal recession in February 2020.
Furthermore, historically, when you have seen extremely steep job losses and a large spike in initial unemployment claims markets have usually been near the bottom.
Potential “buy signal” in the Coppock Guide
This little-known technical tool was originally developed in 1962 by Edwin S. Coppock. By calculation, the Coppock Guide (or Curve) is a momentum oscillator; but in simple terms, it’s described as “a barometer of the market’s emotional state”. In other words, when investor sentiment begins to change, the Coppock Guide reverses direction. Its historical value lies in identifying market bottoms (it’s usually too early to signal market tops).
While calculation of the Coppock is complicated, understanding it is not. Once it drops to “0”, the next upward reversal almost always signals the start of a new bull market. Note by the dashed lines, that an upturn in this Coppock Guide (from “0” or below) has confirmed every significant buying opportunity of the past 85 years!
The Coppock is off today, but when it triggers is a very reliable long-term buy signal. We noted to our clients at the end of May 2009 that the signal triggered and the market was a buy (the S&P was over 30% off the lows at the time, but it went to rally another almost 300% over the next 11 years).
Another key measure that we look at from a technical standpoint is the long term Relative Strength Indicator (RSI) signal for the stock market. This tends to trigger at the same time as the bottom and upturn in the Coppock indicator.
Interestingly, if you go back over the past 25 years, you can see that whenever the VIX has been above 30 for more than three months, this has always led to large rallies. It pays to buy panic and fear. In the case of 2002 and 2009, this marked the bottom of the bear market. In 1998 and 2011, it marked an intermediate bottom along the way of a bull market.
This is an excerpt from our “Understanding Market Bottoms” report from April, 2020. Please contact firstname.lastname@example.org if you are interested in the full report.