October 8th, 2008

What to look for at the bottom

While everyone is watching the markets crash, I’m beginning to look for a strategy as the Index hits a bottom and soon after the MTI gives a green light indicating it’s no longer risky to put money to work. The MTI is a negative indicator telling you when it’s too risk to own stocks. As the market begins recovering from a Bear Market and re-enters a Bull mode we need a more precise strategy.

It would be nice to have a signal derived directly from price action caused by the herd as it migrates among the various industry groups looking for choice stocks to stampede. Is there any relatively easy indicator to alert us of new buying opportunities?

The initial phase of the market’s Life Cycle, Accumulation (the other market Life Cycle Phases are Mark-up, Distribution and Mark-down), is usually the best time to buy stocks because it’s when percentage changes are the greatest. As the Bear Market ends, most stocks begin forming what eventually will be bases. There’s no directional momentum, only sideways movement as market participants remain gun shy looking for signs that confirm the Bear Market’s end.

Stocks price action alone offers little help to identify which stocks will be the future momentum market leaders. Few have completed base-type chart patterns in this phase of the market’s life cycle, let alone breakouts. At times like these, the best strategy may be to let the pro’s do the heavy lifting and spadework for finding compelling values.

We look back a year or more and see how much higher nearly every stock’s price was; there are many “fallen angels”. Everyone is looking to pick up bargains, stocks at marked-down discount prices. But it’s also a time when you’re right to be fear “catching a falling knife”, a stock that looks like it should quickly bounce to previous levels merely because it’s dropped so sharply only to find it continue its descent into oblivion.

I went back to March 11, 2003 (the Tech Bubble Crash bottom) to find the characteristic of stocks that increased the most over the next 6 months ending September 12, 2003. By then the Index was roaring strongly ahead. During those 6 months, over 2700 stocks, or nearly half, matched or beat the S&P’s 26.94%increase. The challenge was knowing on March 11, 2002, before the fact, which stocks were most likely to be among the outstanding movers. Many of the above average performers actually made a V-bottoms: sharp and dramatic declines of up to 70%, to fractions of their pre-crash highs, followed by dramatic percentage recovery moves.

One explanation for this phenomena in the early Accumulation phase of a market’s life cycle might be that nearly all remaining shareholders of these devastated stocks had huge losses. The declines were so rapid and steep they just didn’t have time or the courage to liquidate. With such huge losses, the remaining shareholders held their positions and awaited a bounce offering another opportunity to sell at better prices and reduced losses. Anxious shareholders dumped their stocks in a panic but the remaining ones led a strike for higher prices. Any demand from bargain hunters quickly drove prices up to the point that those older shareholders, fearing losing the opportunity again saw a another opportunity to cut their losses and then started selling.

Taking a leaf from earlier MTI discussions, I tested crossovers and discovered that stocks where the 90-day MA crossed over the 180-day MA were big movers over the next 6 months. Some call these crossovers the “Golden Cross” (more commonly, the cross of a 50-day MA over a 200-day MA). Over 2200 of the 2700 stocks had formed these “golden crosses” by March 12. Approximately half hit their crash lows several months before the Index and had already begun moving to higher ground. Some turned out to be leaders over the next several months.

More later on stocks fitting these specs today.

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