Identifying Market Bottoms

Great fortunes can be had if you can buy stocks at market bottoms!

True, but the trillion dollar question is on how to identify market bottoms.

Catching bottoms is nigh impossible except by chance. In this statement is implicit the assumption that you are trying to get in at the exact lows. It is easier to find God than to catch the exact lows. Such market bottoms can be identified only in hindsight. But even if you can buy when markets are close to a bottom, returns thereafter can be spectacular. The bear market of 2000-2003 bottomed out in Oct 2002 (barring the spike down and sharp recovery post 9/11 WTC attacks). But anyone who had bought over 2002 and first half of 2003 would have made very good returns from stocks. Or anyone who bought stocks in 1997-1998 got very good returns by 2000.

So how do we recognise market bottoms? Market bottoms have certain traits. These are not fool proof, but taken together, they offer a good chance of identifying them. Here are some indicators:


FUNDAMENTAL FACTORS:

GDP growth decline:
Typically bottoms follow busts, which follow booms. So a boom-bust cycle preceeds bottoms. While it is not neccessary that the economy slips into recession, what is common is that there is a sharp decline in economic growth. In the 2000-2003 bear market, India's GDP growth fell by 2.5%. While we cannot be sure how much of a fall there would be, it is clear that economic deceleration is a precursor. This in itself is not an indication though, it merely is a precondition. Often, corporate earnings growths go into the negative, i.e. earnings fall and EPS goes lower. Rarely do we see a cyclical bear bottom with earnings still rising. At best, they stay more or less flat.
Interest Rates:
Interest rates get to low and stable levels. Both rising interest rates and falling interest rates are not the conditions for a market bottom. Rising rates are often an outcome of rising inflation. High interest rates and high inflation are not good for stocks. Similarly, falling interest rates signify lack of demand for money. Which in turn suggests economic slowdown and possible deflation. It is only after interest rates stop falling and stabilise that the spectre of deflation gets over and growth resumes.
Commodity Prices:
Commodity prices stop falling and stabilise. This is but a corollary of falling inflation or deflation since commodity prices affect inflation levels. Stabilising commodity prices tells us that demand supply situation is getting balanced. Stability in commodity prices is generally accompanied by low inventory levels as well. While steel is the most commonly used metal, it is copper prices that have often been a lead indicator.
Liquidity:
Liquidity levels get comfortable and the financial system is not cramped for lack of money. Ample liquidity conditions are usually an outcome of low interest rates. But markets can bottom without excess liquidity. Markets find it difficult to bottom out on tight liquidity conditions.


VALUATIONS:
If bull markets end with stock prices at crazy valuations, bear markets end with prices at the other extreme. Stocks become cheap, whichever way you look at them. PE ratios and P:BV ratios go down, dividend yields become attractive.

How much down and how attractive? That is difficult to say as each bear market is different. But at some point, earnings yield of stocks (inverse of PE ratio) exceeds government bond yields. For example, in April 2003, earnings yield hit a high of close to 8% while the yield on 10 year Government of India security fell to below 6%. (Currently we have a situation where both are neck to neck).

Comparisons across bear market bottoms never yields the same result though. So it is difficult to say what exactly is cheap. In addition, comparisons are never across the same set or companies or industries. But comparing valuations across previous bottoms on parameters such as PE, PBV, Dividend yield, Earnings yield: GSec yields, Price:replacement cost, E:EBIDTA, etc, though never conclusive, is indicative of cheap valuations.


SENTIMENT:
Often sentiment is a very good gauge of market bottoms. In a bull market, there is euphoria. When the first fall comes, people percieve it to be a correction and buy hoping for higher prices. Prices keep falling however and the optimism turns into anxiety. Anxiety later turns into fear as prices just keep falling. Fear converts itself into panic and there is capitulation.

At some stage however, all the selling gets over. But buying does not come in yet. Markets languish and the sentiment towards stocks slowy turns into one of revulsion. People are sick and tired of holding stocks. There is a lot of apathy and disillusionment towards stocks. There is simply no interest towards stocks. People cannot percieve how stocks will ever rise as recent experience suggests that rises do not sustain themselves. People seek comfort in fixed deposits and bonds even as returns therefrom might be pretty low. No one wants to talk stocks.


PRICE ACTION:
Price movements are an important indicator of market bottoms. Here are a few typical price behaviours that suggest that market bottoms might not be far away.
-Volatility in price movements goes way down and stays down
-Prices spend a lot of time inside a range, toing and froing, moving up and down.
-Volumes are low as interest in stocks is low.
-Bad news fails to move stocks lower since all the selling is done with.
-Even good economic news fails to move the markets as no one is interested in buying. In effect the markets go off to sleep.
-Generally bond prices lead the upmove in stock prices. This can happen even as stock prices languish. The impact of rising bond prices is to get the bond yields down, often lower than earnings yields on stocks. Bond prices rise and bond yields drop.

Markets can keep behaving in this manner for long periods. Typically you would see anything between 2-3 years of such behaviour. But this time period is a function of how fundamentals evolve. If fundamentals get better quickly, this base building period could last for smaller periods. Once this period is over, a new bull market starts. How do prices behave at this stage?
-Prices start rising on larger volumes and corrections are on lower volumes.
-Markets start making higher highs and higher lows on prices.
-The initial price rise is on low volatility. Price moves are not large.
-Any bad news gets quickly ignored and prices move higher on bad news.
-Leaders of the previous bull run lag as new sectors and new companies start moving faster than the rest.
-Generally, not neccessarily though, companies with high operating leverages that got hit in the previous cycle, like automobiles, take the lead in performing.
-Most people still call the rise as a bear market rally. Inspite of skepticism for the rise, prices simply keep rising astounding market participants.


It should be noted that the mere occurence of a couple of points in this long list does not indicate a bottom. The above factors should be taken in conjunction with one another. The presence of a large number of the above factors would indicate the possibility of a bottom; a few positive signs in isolation mean nothing. Having said that, markets can bottom and stay down for extended periods. The tricky question, and perhaps more relevant is getting in closer to the start of the bull market. The more relevant question than 'how to identify market bottoms' is 'how to identify a new dawn'.

Happy Investing!