How to ID a Market Bottom
The Five Characteristics I Look For
A Solar Stock Near the Top of My Watch List
As part of Cabot’s market timing methodology, I don’t predict what’s to come. However, I know something far more valuable—as a student of the market, I know (via history) what characteristics show up when the market is toppy, and what signs it gives off when it’s building a bottom.
If you follow these clues, and stick with the market’s overall trend, you’ll benefit from something very powerful: You’ll never be heavily invested during a major downtrend and you’ll never stay on the sideline during a sustained advance. That alone will put you ahead of 80% of investors!
So with that in mind, I want to review the most popular question I’m getting these days: How will I know that the market has bottomed and it’s time to jump back in?
There are the five key characteristics I look for—characteristics that have appeared at nearly every major market bottom for the past 70 years. Here they are.
1. Extremely Negative Sentiment and Breadth Measures
This is one we’ve already seen. As of last Wednesday, January 20, we saw the lowest percentage of bullish individual investors (17.9%) in 10 years; a whopping 85% of all NYSE and Nasdaq stocks below their 200-day moving averages; and that day, the largest number of NYSE stocks hitting new 52-week lows (1,395) since 2008. There are other extremes, too, but you get the point.
Now, the difference is that this is just characteristic #1—many analysts will look at these “oversold” measures and say “That’s it! Capitulation! The bulls are back in control!” But, while seeing extreme sentiment and breadth measurements is good, you have to see more to get a sustainable bottom.
2. A Bottom-Building Process
After large declines (and I think the 15% decline in the big-cap indexes and 20% to 25% drops in small- and mid-cap indexes qualifies), bottoms are usually a process, not an event. You usually need to see a few weeks (or, in major bear markets, months) of ups, downs and re-tests of the initial low.
In today’s scenario, I’m thinking the current bounce, which began January 20, could continue for a while. But at some point, the market is likely to come back down to retest last week’s lows.
“But Mike,” I can hear some of you observant folks say, “wasn’t last week’s drop a retest of the prior August/September lows in the big-cap indexes? And doesn’t that means the market could just surge from here?” It’s possible—but I doubt it, and the reason is covered in characteristic #3.
3. Positive Divergences as the Bottom is Built
When the market builds a bottom, you’ll first see the entire market in shambles, but as the market retests its lows, there will be fewer stocks below their 200-day lines, fewer stocks hitting new lows and more stocks setting up. Said another way, the broad market will hit its ultimate low before the major indexes do—a tip-off that the supply/demand balance is shifting toward the bulls.
During the January selloff, most indexes did NOT hold their August/September lows—small- and mid-cap indexes, and even broader measures like the NYSE Composite, all fell decisively to new lows.
Plus, as I wrote above, the breadth and sentiment measures were worse during this dip than anything seen last year—more new lows, fewer stocks in longer-term uptrends, etc. Anything is possible, but I anticipate some bottom-building in the weeks ahead if last week was the initial low.
4. The Trends Turn Up
I would say 75% of my market timing system is simple trend following. That’s the real secret behind why I never miss a major move in the market—the market can’t go up very far without producing buy signals.
After a bottom-building process, the first of my indicators to flip will be the Cabot Tides—basically, I want to see a collection of indexes (I follow five of them) hit a five-week high. That’s a sign that the intermediate-term trend has turned up.
Eventually, I also want to see my longer-term indicator—the Cabot Trend Lines—turn positive, which means the big-cap indexes have to rise above specific longer-term moving averages and stay there for a couple of weeks.
What happens if these indicators turn positive without a bottom being built (as would happen if the market ripped higher from here)? Well, I would still respect the signals and start buying … but would probably proceed slower than I would otherwise.
A big reason to go slow is that there would be a lack of powerful launching pads, as I write about below.
5. Growth Stocks Powerfully Breaking Out of Trading Ranges
This last characteristic is really a requirement—if growth stocks stagnate and only defensive stocks are going up (consumer staples, utilities, etc.), the rally almost always fails.
After all the pessimism, bottom building and positive divergences, and after the trend indicators have turned positive, I need to see many growth stocks show some upside power. Usually, the first few to reach new highs after a bottom are your leading stocks—and those are the ones I look to recommend in Cabot Growth Investor.
Right now, I’m looking for characteristics 2 through 5—and while I wait, I’m busy working on my watch list, finding stocks that check most of the boxes on my stock-buying checklist (which has 24 specific characteristics I look for).
One name that continues to intrigue me is SolarEdge (SEDG), a little known (but rapidly growing) solar firm. I think it has a chance to be the Intel of the solar industry—it doesn’t make the solar panels or arrays, but has a next-generation inverter architecture that allows for greater efficiency, design flexibility and lower costs. It’s a win-win-win, and because of that, solar firms (especially rooftop providers) have beaten a path to SolarEdge’s door.
Beyond the company, the industry itself got a huge boost in December when the solar tax credit was extended in Congress for another couple of years—the stocks in the sector had already discounted a slowdown, but that good news sparked a huge wave of buying.
SolarEdge is highly profitable, and analysts see sales rising 20% in 2016 (to $581 million) while earnings are expected to leap 36% to $2.06 per share. I feel those figures will prove conservative, though, as the company has trashed estimates in recent quarters.
The stock came public around 20 last March, soared to 43 in June and then crashed to 15 in November, mostly because of the market and fears surrounding the solar tax credit. But the December extension caused SEDG to soar back to 30 on its heaviest volume ever (a big volume clue), and even during the market’s plunge this month, the stock has remained above its 50-day line.
You could nibble on it here with a stop in the 21 area, or just keep an eye on it—the longer SEDG can hold up, the better the chance it can morph into a powerful new leader after the market bottoms out.
To receive further updates on SEDG or additional strong stocks, consider taking a trial subscription to Cabot Top Ten Trader. Each week you’ll receive 10 momentum stocks that have strong fundamentals and opportunity for an advance in weeks to come.
Chief Analyst of Cabot Growth Investor and Cabot Top Ten Trader