Investment—Market Bottoming Process

In this article, we will cover what a market bottoming process looks like and various measures (i.e., rule of 20, breadth thrust, etc.) to look for.

Also read the below companion article:

• Investment—Finding A Market Bottom

Market Bottoming Process

According to Ned Davis Research (NDR), the stock market needs these 4 things to happen before it can find a bottom and starting moving higher again:^[1]

1. Oversold
• The first step is for the market to fall to deeply oversold levels. By several objective measures, the market can be described as oversold.
2. Rally
• At some point, the sellers become exhausted, and the market posts a multi-week rally.
• Importantly, look for broad participation on rallies, including an expanding percentage of stocks above their short-term moving averages and upside volume.
• Note that the average bear market rally after a waterfall decline like the market is currently experiencing lasts a median of 25 days with gains of 14% (as of 05/24/2022).
3. Retest
• Most post-waterfall declines experience retests while noting that prior waterfall declines in 2018 and 2020 did not. For that reason, we would still look for a retest, but leave open the possibility of the market skipping step three.
• The key is looking for positive divergences, such as fewer sectors and stocks making new lows, as well as less total volume and less downside volume.
4. Breadth Thrusts
• The early stages of a sustained uptrend often include most stocks rallying together. 
• That way, if a few industries falter, plenty of others can support the popular averages. 
• An extremely high percentage of stocks rallying is called a breadth thrust.

Rule of 20 vs S&P 500 (Credit: Real Investment Advice)

Market Multiples / Valuation Multiples

Valuation multiples are financial measurement tools that evaluate one financial metric as a ratio of another, in order to make different companies or cycles more comparable.  The below are some samples of valuation multiples:

1. Rule of 20
• The value of the markets is fair when the sum of the P/E ratio and the inflation rate equals 20.
• P/E + Inflation = 20
• The stock market is undervalued when the sum is below 20 and overvalued when the sum is above 20.
• The combined P/E ratio and inflation rate have ranged from a low of 14 to a high of 34.
2. Profit Margins
• "Profit margins are probably the most mean-reverting series in finance. And if profit margins do not mean-revert, then something has gone badly wrong with capitalism", said Jeremy Grantham.
• The only question is when the markets begin to realize it.
3. Inflation-Adjusted $SPX
• $SPX can go up but inflation could go up faster (read [9] for more details)

Bottom Line

The bottom line is that the market has achieved the first step (oversold) and is attempting the second step (rally). Until the market can move to step four (breadth thrusts), NDR views the [bottoming] process as ongoing.  Some bottom signals could include:

• A record inflow of funds from a certain asset could signal that the end of bear market
• Buy when retail sells and sell when retail buys

Finally, be warned that each cycle is different.  As Howard Marks at Oaktree Capital Management has commented on the current cycle:^[2]

“There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent.”

Figure 1.  S&P 500 % of stocks > 50d MA (Courtesy: stockcharts.com; Also Read: [7])

Video 1.  How To Find The Major Turning Points In The Market with Avi Gilburt (YouTube link)

References

1. The stock market needs these 4 things to happen before it can find a bottom and starting moving higher again, Ned Davis Research says
2. The Rule Of 20 And Why The Bear Market Remains
3. 11 macroeconomic indicators measuring inflation, fear and uncertainty
4. 11 data sources that have HIGH QUALITY and FREE data you can access
5. How to make a 10-bagger (a stock that goes up tenfold)?
6. How to read an income statement?
7. Does Quick Drop To 20-Day Low Invalidate Recent Breadth Thrust?
• Breadth thrust looks at times the % of SPX stock above their 50ma quickly rose from <= 15% to >= 90% within 50 days
8. Investment—Finding A Market Bottom
9. Technical Analysis—SPX / PPI Price Relative
10. Investment—Market Topping Process
11. Reflections on recession, inflation and earnings