Today, we’re walking through how investors can spot a market bottom. In contrast to market tops (extremely difficult to reliably identify), market bottoms follow a repeatable pattern, and, because the market goes up over time, come with far fewer false positives than major tops.

Brown Technical Insights uses a three-step process for spotting market bottoms, and it can be applied to major indexes or individual groups

Step #1: The Washout

The first step in a market bottom is a washout. That’s the panic, extreme fear, and capitulation that come with a large downward thrust in the market.

We’ll be hopping back and forth between bear markets, but our first chart shows two washout signals for both the 2018 near-bear market and the 2020 Covid crash.

What we’re looking for is a combination of pessimistic sentiment, oversold market internals, and signs investors are paying up irrationally for protection and hedges. A few specific examples include:

• Less than 15% of stocks above their 50-DMA
• More than 30% of stocks registering an oversold reading (RSI-14 below 30)
• Greater than 70% of SPX stocks making a one-month low
• Spike in the 5-DMA of the put-call ratio
• An inverted VIX curve

Importantly, this is where the bottoming process begins, but it is rarely where the index price low is found. You may also get multiple washouts in a longer-term bear market that mark tactical lows, but can’t be expected to be the ultimate low without the additional steps in the process.

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Step #2: The Bullish Divergences

In Step #1, we noted that the washout is rarely where the index low is found. Step #2 will show why that’s the case.

Following a washout, you often see a short-term bounce in the index. When the index rolls over to a new low or retests the low, similar capitulation signals to Step #1 are common and if market internals are worse than the prior index low, it’s a good signal the bottom isn’t in yet.

That was the case in June 2022, when the index made a new low and had a multi-year high in the percent of stocks at a 3-month low. The index saw a big bounce higher, but rolled over and made a new low in October.

But, while SPX undercut its summer lows, the majority of stocks didn’t. Fewer stocks made a new low in October (what technicians call a bullish divergence), and once the index moved back above the June lows, the divergence was confirmed.

Step #3: The Breadth tTrusts

Finally, once the index low is in, buyers come into the market in full force. While bear market rallies can see huge headline gains, the tell under the surface is often weak breadth. Once the low is in, multiple breadth thrusts (or signs of aggressive, broad-based buying) are common. A few of my favorites to watch for include:

• Greater than 90% of the S&P 500 getting above their one-month moving average
• Greater than 55% of S&P 500 stocks hitting a one-month high
• Multiple days of better than 7:1 advancers vs. decliners on the NYSE
• Multiple days of 90% up-volume on the NYSE

And there are certainly others. But each unique breadth thrust is consistent with above average forward returns for the index, and while you might get one or two in a bear market rally, a collection of them are rarely seen until the ultimate low is in.

Once you’ve seen all three steps, that’s the buy signal. As shown in the examples above, fear and skepticism reign supreme shortly after a low (think back to the summer of 2020) but the checklist had seen everything it needed. It was a full-on signal to overweight equities.

The process detailed above does require investors to consider various metrics at each step. But the psychology and internal price action behind it are amazingly consistent and can help investors take advantage of pullbacks while still maintaining buy discipline amid bear markets.

Brown Technical Insights helps financial advisors and retail traders make better investment decisions by focusing on price, history, and data, rather than headlines and emotions. If you’ve found value in the articles this week, consider taking advantage of the offer above for 50% off your first year (a $549.50 savings).

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Shared content and posted charts are intended to be used for informational and educational purposes only. CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. CMT Association does not accept liability for any financial loss or damage our audience may incur.

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