How to Tell a True Market Bottom

ByKen Shreve, Portfolio Manager

Throughout history, market bottoms and the ensuing uptrends have shown price and volume trends that recur with an eerie regularity. For investors, the question is, how do you spot a follow-through day? I've been watching follow-through days for the past 14 years, and they have a good track record of flagging bottoms.

The current market pullback is still young, but when one occurs, it's important to be ready.

Basically, market bottoms are put in when new institutional money starts to go to work again. Obviously, this isn't happening now, but new market uptrends tend to start when they're least expected, so it's important to watch for a follow-through day in coming days and weeks. Uptrends can start amid a lot of negative headlines.
What to Watch For

I learned a system for identifying bottoms from my former boss, Bill O'Neil, the founder of Investor's Business Daily. He's a savvy, highly profitable stock-picker who has an uncanny sense of when to be in the market and when to be out. His system of identifying bottoms has a good record of success. It's not perfect, but it's pretty darn good. Here's how it works:

As the market is heading lower, like it is now, look for Day 1 of a rally attempt; basically, any up day for an index. The percentage gain doesn't matter, nor does the volume. After that, wait for the fourth day of the rally attempt and then look for a big percentage gain in at least one index with volume coming in higher than the day before. Volume doesn't need to be above average, just higher than the prior session. So follow-through days must occur on Day 4 of the rally attempt, or later.

In the past, follow-through days like these have sparked several bull markets. They have also launched shorter-term, tradable rallies. These can be profitable as well. Also keep in mind that rallies can fail. During a rally attempt, if a prior intraday low in the index gets undercut, the rally attempt is killed, meaning it's time to look for Day 1 of a rally attempt again.

An Example From 2009

The market bottom that was put in last year in March was picture-perfect.

March 6 was Day 1 of the rally attempt. On March 12, Day 5 of the rally attempt, the S&P 500 surged 4.1%, and volume rose from the prior session -- a classic follow-through day that launched a big market rally.

Green Mountain Coffee RoastersNasdaq" PRIMARY="NO"/> was one of the first stocks out of the gate when the S&P 500 followed through on March 12. It cleared a five-week consolidation during the week of March 20. It broke out to new high ground and never looked back. It was also the time when several fast-growing China names started big moves.
The Current Setup

The recent market pullback seems to be gaining traction. As I wrote last week, what's different this time around, compared with other pullbacks in recent months, is that market leaders are under more duress - in other words, they are technically damaged. It'll probably take a while for the selling to run its course, but at some point the market will flash a follow-through day.

In the context of the current market, Monday, Jan. 25 was the first day of a rally attempt for the S&P 500, but the rally was killed the very next day because the index's intraday low set on Jan. 22 was undercut. Wednesday was Day 1 of a rally attempt, but the intraday low on Wednesday was undercut on Thursday. Rally attempt dead again. Fresh lows were hit on Friday, so I'm still looking for Day 1 of rally attempt. If we get one on Monday, the earliest we could see a follow-through day would be on Thursday. If we close higher Monday but Monday's intraday low gets taken out on Tuesday, the rally is dead and it's time to start looking for Day 1 of a new rally attempt. However, if Monday's intraday low doesn't get taken out, the earliest we could see a follow-through day would be on Thursday -- Day 4 of the rally attempt.

When you see a follow-through day, it's important to have a watch list of stocks that have strong fundamentals and technicals. These types of stocks can be the big winners. Earlier this week, PegasystemsNasdaq" PRIMARY="NO"/> cleared a type of base you want to see on or around a follow-through day. Technical breakouts like this can yield powerful gains after a follow-through day. Of course, the issue with Pegasystems is that it broke out in a market that is generally under distribution -- not the best of environments for breakouts to succeed.

Keep in mind that the market has to be consolidating for only three weeks. Follow-through days can work after short pullbacks, but they have a better track record of success after a meaningful market decline. A market pullback that lasts at least five to seven weeks, or longer, will normally give stocks time to set up in proper bases.


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