Chapter 8 on “Spotting Bottoms in Stocks” is one of the best sections of Jim Cramer’s Real Money (review). The chapter is filled with the type of insights you would expect to get from someone with 25 years of experience in the market.
The chapter does discuss spotting bottoms in individual stocks, but Jim spends most of his time on indicators he uses to spot market bottoms. These indicators (collected into three categories) have been shared by all four of the last big market bottoms (1987, 1990, 1998, and the “double bottom” in 2002-2003).
Note: All quotes are from Jim Cramer’s Real Money unless otherwise noted. I’ve cited which page the quote comes from so readers with the book can follow along at home.
1. Market Sentiment
The first group is a collection of the following indicators. The theme here is that bearish sentiment implies that money has already been pulled out of the market and is itching to be reinvested.
- “The pain makes the front page of the New York Times” (page 212).
During a downturn, there will tons of market pundits (and bloggers) writing about how terrible things are. Only when the news hits the front page of the major papers will we consider the market officially bottomed-out.
- The Investors Intelligence survey of money managers.
You can get these numbers, which surveys fund managers and compares the % of bulls vs. bears, in Investor’s Business Daily every Thursday, or Thursday nights at Market Harmonics. Cramer is watching for a majority of bears and less than 40% bulls. The idea is that people bearish about the market have already pulled their money out and thus can’t pull the market lower. For more of this kind of discussion, check out the blog Trader’s Narrative, which has an interesting analysis of the American Association of Individual Investors (AAII) bearish sentiment numbers.
- Mutual fund withdrawals.
Cramer is looking for “consistent, repeated outflows of several of several months” (page 215).
- The Volatility Index (VIX).
Is the market in a panic? Cramer is looking for readings above 40 in the VIX.
VIX at Investopedia.
There are a lot of oscillators out there. In general, they are used to indicate when a stock (or market) is overbought or oversold. Jim swears by Helene Meisler’s oscillators over at RealMoney.com, but you’re going to have to pay to see them. Phil Town uses the Fast Stochastics. While Bill Cara is a big fan of the Relative Strength Index (RSI).Once again, Investopedia is a great place to start for Getting to Know Oscillators.
This next set of indicators is all about finding a “crescendo” in the market, that last big sell off before the bulls move back into the game.
- “A dramatic imbalance in the amount of new highs to new lows”.
We’re looking for a large number of new lows and not very many new highs. Cramer looks for “between four hundred and seven hundred new lows and only a handful of new highs” (page 217).
- Forced margin selling.
Investors trading on margin (borrowing money from their broker) need a certain amount of money in their accounts to “maintain” their margin. In down-trending markets, these investors are going to lose so much money that their brokers will force them to sell their positions. Cramer depicts a scenario where the brokers try to get some more money out of the traders during the morning before laying down the hammer and forcing a sale of the trader’s positions sometime between 1:30 and 2:30 in the afternoon. For this reason, Cramer watches for a spike in sell offs between 1:30 and 2:30PM. When the spikes stop coming for a few days, the margin sellers are shaken out and the market bottom is near. I found a surprising source in the SEC, while looking into this:http://www.sec.gov/investor/pubs/margin.htm.
- “A dramatic spike in volume on the exchanges” (page 219).
Cramer gives an anecdote to explain this one. I won’t re-tell it. So you’ll have to pick up the book (the book!). The lesson: “Let this serve as a reminder to you not to sell into the big volume after a long decline. That’s the time to buy, not sell” (page 220).
- Flow of underwriting.
“You don’t commit capital until the most recent underwritings have worked” (page 220). Cramer describes a cycle of IPO and underwriting activity. It goes something like this: IPO stock prices go up for no reason » IPO stocks are pretty level after the offering » IPO stocks are trashed after the offering » (again) IPO stocks are pretty level after the offering. You want to buy into the market when this last situation is prevalent.
- Order imbalances.
“Repeated order imbalances sans news are sure signs that the capitulation has reached absurd levels and you have to make your move to buy” (page 222). You’re only going to see this message if you’re on the trading floor, but maybe someone will report/blog about it if they started showing up more often. Order imbalances at Investopedia.
Jim’s stance is that all market bottoms are associated with a real world event. This catalyst brings on an “exquisite moment”, where “you have to buy because the opportunity is so great” (page 222). Previous catalysts were surprise rate cuts by the Fed (1998) and the start of the Iraq war (2003). Amazon’s poor earnings probably doesn’t count. Israel waging war on Lebanon/Hezbollah is probably not going to cut it either, but further US involvement could lead to a catalyst. You can’t necessarily predict the catalyst that will surge us into the next bull market, but you can try to be ready for it.
BONUS – How to tell if you’ve missed the bottom: Jim suggests watching the Bank Index (BKX), which has some typical behavior during, or just after, a big market bottom. “If you see a 10 percent move up in the Bank Index you are already well into the upswing, and it might pay to wait for a couple of profit-taking days to transpire before you commit capital” (page 224). Jim doesn’t give a time frame for the jump. Here’s a chart of BKX from Yahoo. There was a 10% jump last October, which did correspond with a large rally. Presumably, we’ll see another jump at or after a market bottom.
We may not be near the market bottom right now, but a lot of people seem to think we’re on the way. Keep these indicators in mind if things don’t turn around. You’ll want to be able to spot the bottom when it comes.