How to Spot a Market Bottom

So, what does history tell us? Well, as nice as it would be, the markets typically don’t wake up one morning and say “enough is enough!” then set out on an uninterrupted bull run that creates a V shape on a market graph. What’s more common are a lot of false starts: rallies that ultimately lose steam and cause a retrenchment — maybe not all the way to the previous low — before picking up steam again. Eventually the retrenchments stop and we move into a period of sustained bull growth. Think stair-step rather than express elevator. As Liz Ann Sonders, chief investment strategist at Schwab puts it, “market bottoms are processes over time, not moments in time.”

There is no shortage of market, economic and sentiment indicators that are used to measure how far or close we are to a bear market bottom. Indeed, viewed in a historical context, many look downright prescient. But as they are forced to say in the mutual fund business, past performance is no guarantee of future performance. The same is true of bear bottom indicators. “If we knew exactly which metrics always worked to call a bear market bottom, then we would see active managers with a serious performance edge over index funds coming out of bear markets, but that’s not what has happened,” says Vanguard’s Kinniry.

So with that caveat firmly in place, here are some indicators that get heavy rotation when the topic is spotting bear market bottoms:

• Economic news morphs from awful to merely bad. If you wait until the economic news — GDP growth, unemployment claims, housing starts — regain their footing and post positive growth, chances are you will have missed the early stages of a bear-market recovery. Turns out Wall Street is usually ahead of the economy; typically market reboundsbegin about five to seven months before the economic signals start flashing recovery. And as explained below, you don’t want to miss that first leg of the market recovery, which is usually the strongest. So that means taking the silver-lining approach to reading economic indicators: ask yourself are they indeed getting worse, or is the bad news a little less bad than the previous month? Spot a few months of less-bad news and you’re likely looking at the early gestation period for an economic recovery. Of course, there is no way to know how long the gestation period will be, but just remember, the market has historically recovered first.
• Investor sentiment is sour. Sorry to have to be so blunt, but individual investors tend to be useful contrary indicators: We have a proclivity for feeling most bullish at market highs, and most bearish at market lows. That’s exactly the opposite of what you want to do to make money over the long term. So one useful indicator is to take a look at how we’re all feeling and try to do just the opposite. The American Association of Individual Investors (AAII) has produced a weekly investor sentiment survey since 1987. On average over that period, 30 percent of investors feel bearish. But on March 5^th of this year the bearish level shot up to 70.3 percent. Since then, the S&P 500 has rallied more than 20 percent. Conversely, the day before the tech bubble reached its March 2000 peak, just 16 percent of respondents were bearish.
• The volatility calms down. The CBOE’s Volatility Index, the VIX, is known as the market’s fear gauge. It measures option writing on the S&P 500 index; when the VIX is high that’s a pretty good tip-off that markets are cruising for a bruising. When the VIX is lower it can signal higher market returns. Last November the VIX was at 80. Today it is sitting at 40, a 20 percent decline since early March. As the VIX settled down the past month, the S&P rallied 26 percent.
• Commodity prices stabilize. No advanced econ degree needed here; when economies get back to growing, demand for commodities follows suit. When that happens you can smell a bear thawing. The Dow Jones-AIG Commodity Index is down more than 50 percent from its 2008 peak, yet over the past month it has rallied nearly 10 percent.
• Valuation measures suggest a sale. It makes perfect sense that a low price-earnings ratio on the S&P 500 would be a good gauge that we are just a rest stop or two from a market bottom. But it all depends on what P/E you are using. Right now, if you look at trailing 12 month earnings, the market looks a tad expensive with a 25 P/E. Flip over to forward-looking earnings estimates and suddenly the P/E is down to bargain territory of 11.9. Then there’s the fact that the E part of the equation isn’t easy to pin down right now, as businesses struggle to cope with the double whammy of a severe recession and the credit crisis. “Earnings estimates are so questionable right now, we’ve backed off a little in using P/E-based indicators to gauge the market,” says Brad Sorenson, chief sector analyst at Schwab. As an alternative to P/Es, Vanguard’s Kinniry watches the real (inflation-adjusted) return of the S&P 500, which historically averaged 6.75 percent. The S&P’s level right now is well below that historical long-term trend line, suggesting to Kinniry that there is value to be had in stocks.

We’ll make this quick, but it’s time for another installment of “timing the market is a risky proposition.” While it is hard to know the exact point when the bear market will reach its ultimate bottom, we do know that once it does reach its low point, it tends to skyrocket quickly. A study of the past nine bear markets since 1950 by the investment firm JennisonDryden found that in the first year after a bear market trough, the average gain for the S&P 500 was 36 percent. In year two: 12 percent. Year three: 1 percent. If you’re sitting in cash for any part of that first year you’re likely to miss some serious gains.

Now that’s not to suggest it’s time to go 100 percent into stocks with the hope of making up for lost ground. If there is one big takeaway from the meltdown it’s the need to have a diversified portfolio of stocks, bonds and cash for the long term. That said, you sure don’t want to be underweight in stocks near a market bottom. “You really want to be thinking about rebalancing right now to make sure you’re still on target with your stock allocation,” says Kinniry.

If you’re ready to put new money to work, Schwab’s Sorenson recommends dipping your toes back in rather than an all-out swan dive. “Given our expectation that we will see rallies and pullbacks as the market goes through the bottoming process, dollar cost averaging makes sense. When you see a pullback, use that as an opportunity to put some more money to work.”