3 Keys To Spotting A Market Bottom

Simon Maierhofer Wednesday November 19, 2008 Imagine this: For hours you've been working on an important Microsof Word document, after you are done, you close out the file but forget to save the file. Shoot, hours of work are lost! Have you been fully invested while the Dow fell from 14,000 to 7,800? Not locking in unrealized gains is like forgetting to hit the 'save' button. Since you obviously missed to call the top, the question most foremost in your mind is 'Where's the bottom'? According to many, finding a stock market bottom (or top) is like catching the ominous falling knife. Wall Street finds itself divided about the validity of spotting market bottoms. On one hand they are quick to dedicate entire front pages of newspapers to 'we hit rock-bottom' articles, on the other hand they promote that it doesn't matter for long term investors. Personally, I like to adhere to a pro-active asset allocation approach. This sounds fancy but is simple. Rather than sticking with a stale asset allocation model, you tweak (exit or enter) positions according to market behavior. On a very basic level, this means that cash or bond ETFs, in particular short term treasury bonds (NYSEarca: SHY - News) are overweight in a bear market. I don't subscribe to the buy-and hold until you die notion or cash is trash. Take a look around, cash has been king. Benefits of spotting a bottom You don't need to be a rocket scientist to see the benefit of spotting a market bottom. For our Ready-To-Go Portfolios (ETFguide's subscription based ETF model portfolios), we sold the iShares FTSE/Xinhua China ETF (NYSEarca: FXI at its all time high of $219 (pre-split) on October 17, 2007. FXI has shed 70% of its value since. In the middle of September we added a couple of short ETFs such as the ProShares UltraShort S&P 500 (AMEX: SDS - News) and the ProShares

UltraShort Consumer Services (AMEX: SCC - News). We've owned the UltraShort Financials (AMEX: SKF - News) and UltraShort Real Estate since May and August of 2007.

Naturally, we are looking for a market bottom to unload short ETFs to avoid a performance drag in a sustained counter trend rally. Let's not call it market timing, but with a pro-active, common sense approach, you can beat the major benchmarks such as the S&P 500 (AMEX: SPY - News) and Dow Jones (AMEX: DIA - News). In fact, five of our six portfolios have outperformed the S&P 500 every single year since 2005. Beware of decoy bottoms A quick glance at the Dow Jones' long term chart reveals that the Dow often forms decoy bottoms. Such fake bottoms are followed by a brief rally which soon gives way to lower lows. The markets seem to take pleasure in seeing investors throw good money after bad money. The Dow's all-time depression low of 1932 was preceded by at least seven levels that were considered major market bottoms, only one actually was. Looking at today's market, we don't expect to find a long term low, we aim to identify a level that will serve as a springboard for a sustainable (several weeks to several months) counter trend rally. How to spot a bottom Investors and wanna-be investment advisors often rely on one factor to find a bottom while in reality there are at least three, consider them a composite sign or formula. The Volatility Index (VIX) and Investors Intelligence Survey The CBOE Volatility Index (VIX) and Investors Intelligence Survey are contrarian sentiment indicators and as such follow Warren Buffett's philosophy of: 'it's time

to be greedy when others are fearful'. The VIX is often referred to as the 'investor fear gauge'. At the zenith of fear, sellers will have been weeded out. With sellers gone, the market can only go up. The VIX shot up to 89.53 on October 27th, a record level. Each week Investors Intelligence surveys some 140 financial newsletter writers to determine whether they are leaning bullish or bearish in their opinions to subscribers. The current bull/bear ratio of 0.44 is one of the lowest on record. Divergence What carries more weight, a unanimous vote or a majority vote? No doubt a unanimous vote would instill more confidence. Similarly, a unanimous signal from the major benchmarks carries more weight than a fragmented signal. On October 27th, the NASDAQ (Nasdaq: QQQQ - News) and the NYSE Composite (NYSEarca: NYC - News) made new (intraday) lows, while the Dow and S&P did not. While a unanimous signal by the major benchmarks is not required, the absence of one leaves room for doubt. Breadth and capitulation The October 13th rally saw 18.77 stocks go up for every stock that was down (18.77:1). NYSE up volume was a heavy 95% of total volume. Ironically, elevated breadth figures do often occur during bear market rallies. The biggest breadth days in history were in counter trend rallies, most between 1929 and 1932. Capitulation is somewhat linked to the VIX, which hit record levels on October 27th. Futures were down limit the night before. There were some indications of panic but when the pit session opened, the stock market rallied back, showing limited downside market action. What we didn't see was a record spike in NYSE volume or record downside NYSE breadth. Did we hit bottom? Technically, most requirements for a (temporary) bottom have been fulfilled. I'd be buying too, if it wasn't for the lack of capitulation and the still positive posture of talking heads a la CNBC and Fox. The market tends to move contrary the conventional wisdom of Wall Street which seems to be buying the bottom. This leaves the door open to break the October 10th lows within the next few days or weeks.

Smart Money Magazine, Wall Street Journal, CNBC and others viewed low valuations as a sign to jump all into stocks and real estate, this was just days before the markets crashed. That's exactly the kind of Wall Street wisdom to run away from. If you are tired of being fooled by so-called professionals and getting tricked by the markets themselves, join a winning team and become a subscriber to our Ready-To-Go Portfolios. We don't do magic, but with good old common sense we beat Wall Street year after year.