Trusting the Rally
By Brett N. Steenbarger, Ph.D.

It was Thursday, October 10^th and the S&P 500 Index was rallying off a morning low that had dipped below its July bottom.  As the market roared into positive territory, I commented to a friend, “This rally looks for real.”  His response took me a bit by surprise given the seeming market vigor.  “No way,” he declared.  “I’m not getting in.  I don’t trust this market.”

In retrospect his response made sense.  Since the peak in the S&P 500 Index, we have had a decline that has cut the average nearly in half: from 1527.51 on March 24, 2000 to 768.63 as of October 10, 2002.  As Table One indicates, during that period we have had five rallies of 10% or more in the S&P, including the recent bounce off the Thursday low.  Four of those five rallies ultimately gave way to significantly lower prices.  Beneath my friend’s response is an important question: What is to say that this is the rally that can be trusted? 

In this article, I will take a look at historic market bottoms and attempt to draw a profile of bottoming processes.  The goal of this profiling is to discover objective criteria that can inform investment decisions that are colored neither by the greed of bottom fishing nor the fear of market weakness.  As we shall see, the profile that will emerge may prove most useful in determining whether we are witnessing the beginning of a new bull market or just another load of bull courtesy of the bears.

A Psychological Perspective on Profiling
Creating a market profile to build trust in investment is akin to a strategy I employ with clients who have been burned in romantic relationships.  Very often the hurt party has experienced a series of disappointments in one or more relationships in which trust was betrayed.  This makes it difficult to contemplate entering new relationships.  “I just don’t trust men!” is a common refrain among many women I have counseled following a marital infidelity. 

This, of course, creates an emotional Catch 22.  It is impossible to regain trust in relationships without experiencing trustworthiness, and it is impossible to re-enter a relationship until a measure of trust has been regained.  The dilemma of the investor is similar.  Successful experience is needed to regain confidence in the market, and yet the investor cannot achieve such an experience staying on the sidelines!

The profile I create with my clients helps address this quandary.  We go back in time and review every significant relationship the person has experienced: trustworthy and untrustworthy ones.  We carefully catalog the characteristics of the trustworthy people, and we ferret out the similarities among those who cannot be trusted.  Although this is unpleasant at first, reminding people of painful experiences, it soon becomes an enjoyable task.  As the profiles of the “good” and “bad” people take shape, people realize that there are patterns to success and failure in relationships.  If they can gradually move forward with dating, screen people based on the profiles, and begin relationships with only those who display the positive patterns, suddenly it becomes possible to pursue relationships while building trust.  The profile places the client in a position of control by ensuring that he or she will only give their heart to a worthy partner.

A profile of market bottoms, I propose, might accomplish something similar.  What we will look for are characteristics in the market that distinguish long-term bottoms—ones that yield meaningful ongoing rallies—from short-term bottom points that are ultimately reversed.  This will require a fair amount of cataloguing, but ultimately should provide investors with a heightened degree of control as they contemplate re-entering roiling market waters.

Profiles of Market Bottoms I:  New Annual Lows
As I reviewed summary statistics of major market bottoms from 1965 through the present, one statistic immediately jumped out at me.  Whenever the number of stocks making new 52 week lows swamped the number making new annual highs, a rally was shortly at hand.  From a psychological vantage point, this makes sense.  At market bottoms, investors are dumping the stocks of good companies along with the bad.  The surge in the number of stocks making 52 week lows suggests that selling has reached exhaustion levels of negativity.

Finding a threshold number of annual new lows for testing my hypothesis was a bit tricky, since the number of stocks traded over the past 40 years has expanded significantly.  Accordingly, I calculated the number of new 52 week lows as a percentage of the issues traded for that day.  My cutoff point was 25%:  I looked at the market making a potential bottom whenever one fourth of the issues traded that day hit 52 week lows.

To begin the profile, I examined 8954 days from March, 1965 to October, 2000, focusing on the S&P 500 Index.  My goal was to predict the market’s subsequent movement over the next 500 days, which is roughly a two-year span.  Interestingly, there were only 63 days in which 25% or more of NYSE traded stocks made new annual lows.  On 56 of the 63 occasions, the market was higher after 500 days.  A negative return was achieved only 7 times.  The median change for the 63 occasions was 34.18%, which more than doubled the median gain of the S&P for the remainder of the sample, which was 15.44%.  In other words, an investor who bought stocks when 25% or more of issues were making 52 week new lows achieved double the return of an investor who bought at other times, and they made money on roughly 90% of occasions.  That seems like a promising start to the profile.

While promising, however, the new lows indicator is far from perfect.  On many occasions, the market registered 25% or greater new lows only to fall even further and expand the proportion of stocks trading at an annual nadir.  For example, we hit the threshold level in May, 1966, but did not bottom in the market until October, when prices were lower.  Similarly, the 25% criterion was hit in July, 1974 and August, 1998, but prices did not bottom until lower levels were achieved in December and October of those years respectively.  Making an investment when the market first registered a quarter of issues making new 52 week lows subjected intrepid souls to a fair degree of drawdown in their accounts, even though they generally came out ahead 500 days later.

The 7 occasions when the market lost money 500 days following the attainment of the 25% benchmark all occurred in 1973.  The market dropped precipitously from its 1972 high, but did not bottom until 1974.  It is quite likely as well that the extended market declines during the 1930s and 1940s might have shown negative 500 day returns as well, although data on stocks making new annual lows during that time were not available to me for testing.  The conclusion, then, is that a surfeit of new lows may be necessary to the making of a durable market bottom, but not sufficient.  We need to elaborate our profile.

Profile of Market Bottoms II: Market Advances
In a recent MSN Money article that I wrote with Jon Markman, we reported on the research of Lowry’s Reports, which undertook a similar profiling of market bottoms.  They discovered that important market bottoms were characterized by a series of days in which 90% of volume was concentrated in declining stocks and 90% of all price change registered by stocks was negative.  Following this series was a series of positive 90% days, which displayed the reverse pattern.  It appeared from the Lowry work that a second characteristic of market bottoms is a level of pricing that is so attractive to long-term investors that it yields a buying stampede.

I decided to test this idea by tracking the proportion of stocks traded during the day that advanced in price relative to those that either declined or remained constant.  Specifically, I set a 60% threshold, and declared that any day in which 60% or more of issues traded were advancing was an “upthrust” day.  I then examined important market bottoms since 1965 to see if there was a pattern to these upthrusts.  I especially focused on series of upthrust days that were not interrupted by “downthrust” days, in which 20% or fewer of traded stocks advanced.  Table Two summarizes these results. 

A series of four upthrust days (four days in which advancing stocks constituted 60% or more of issues traded) without an intervening downthrust day (a day in which advancing stocks constituted 20% or less of issues traded) typified the action following a major bottom in which 25% or more issues traded registered annual new lows.  Conversely, when 25+% of issues reached 52 week new lows but four uninterrupted upthrusts were not attained, the market was more likely to continue lower before eventually bottoming, as in 1973, 1981, and August, 1990. 

This supports the notion advanced in Lowry’s Reports that a bottom is not in place until buyers perceive such value that they flock into the market.  The criterion of 60+% advancing issues in a day appears to capture this dynamic.  Note, however, that, while the buying fervor often occurs shortly after the ultimate low is reached, there can be a considerable delay.  We did not see a series of upthrust days following the October, 1990 low, for example, until early 1991.  It is also possible for the market to make a marginal new low on some indexes following a valid series of upthrusts, as occurred in 1974.  Although the market upthrusts occurred in October, 1974, the Dow Jones Industrial Average made a new low in December of that year before the market took off in 1975 with a series of five uninterrupted upthrusts from December 31, 1974 through January 10, 1975.

Where Do We Stand Now?
At the July 24^th bottom, we registered 26.66% of stocks making new 52 week lows, meeting our first criterion of indiscriminate selling.  Between July 29 and August 26, we had nine uninterrupted upthrust days, exceeding our second criterion of four such days in which buyers perceive unusual value in the market.  Recently, on October 10^th, we made a marginal new low in the S&P, much as did the Dow in December, 1974 following the October upthrusts.  If the July signals are valid for a coming bull market, we should see considerable upthrust from the recent October low.  Indeed, since that point we have registered two upthrust days on October 11^th and 15^th.  We need at least two more such days, uninterrupted by a downthrust day, to adequately sound the all-clear signal.  While there is no guarantee that such a series of days will generate outsized returns to the upside for months to come, the historical record certainly favors 500 day periods following downturns in which more than a quarter of traded issues make yearly lows.  When a series of upthrusts follow such downturns, the record has been unblemished since 1966.

It is likely that other criteria of extreme selling and buying could work even more effectively than the two that I have incorporated in the current profile.  Regardless of the criteria and testing employed, the important idea is that investors can regain their footing by trusting their research, rather than trusting the market.  Like my risk wary clients who pursue good relationships by keeping their profiles firmly in mind, it is possible to pursue promising markets by staying disciplined in time-tested criteria.  We are not yet at a point where bulls can uncork the champagne, but the profile suggests we are not far from that point either. 

Brett N. Steenbarger, Ph.D. is a clinical psychologist and active trader, writer, and researcher for the past 20 years, Brett is the author of The Psychology of Trading (Wiley; 2003) and numerous articles on trading psychology for print and online financial publications.  Click here for full bio >>