That’s Gonna Leave A Mark

It’s often said that picking bottoms is easier than picking tops. Logically this can really only be the case if people are using somewhat different definitions of bottoms, but I think for most it remains true in practice. However, bottom calling based on one or two indicators, while ignoring the larger context, can lead to trouble.

I always think of Tommy Boy getting bashed in the head with a 2×4. When a significant decline or negative event happens, it’s going to leave a mark. There will be echoes that reverberate through the markets as people adjust to the new reality, and how long that lasts will be somewhat proportional to the size and circumstances of the decline.

As an example, here’s a fairly run of the mill decline from the Fall of 2011:

The first drop wasn’t huge, less than 20% top to bottom, and ended with a typical volume spike. The EU troubles were in the news, along with the usual wall of worry, but mostly the market had gotten overextended. After the first bottom, the market chopped around for a while before it retested the lows, but on lower volume. There was another low volume head fake, but that’s pretty much all she wrote. Basically a slap in the face with no lasting damage, consistent with the overall context.

On the other hand, the late 2007 to 2009 period provides a great example of leaving a mark:

Though the news near the end of 2007 might have predicted otherwise, the initial drop in early 2008 was fairly normal. The period between the two bottoms was perhaps longer than the percentage drop would indicate, and the rally attempt was somewhat abortive, but the action still reflected a market taking a fairly typical heavy blow. But at that time that reaction itself was a problem since it didn’t reflect the magnitude of events that were happening. The news continued to worsen but the market rallied for a couple of months in Playtex mode (no visible means of support) before failing to make new highs.

The initial bottom after the Playtex rally could easily be rationalized as the start of a long trading range along the lows while things worked themselves out. Looking only at the chart, it was a good place to scale back in; all that was needed was a rally and retest. In fact, without paying attention to the broader context, there were four, and maybe five, justifiable candidates for a good bottom as they were happening. Instead, context grabbed a 2×4 and swung it with both hands, and jumping in at those seeming bottoms would have been ugly.

There are many indicators which can be used to signal a bottom: Breadth, volume, new lows, daily range, volatility, options ratios, and others. But nothing is foolproof in the markets – banks have paid a lot of bonus money to people who’ve proved it – and considering what mark the broader environment will leave can help improve your odds. Was that a fist or a 2×4? 

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