Spotting Bottoms in the Stock Market

When stock prices are so low that they are out of sync with reality, fortunes can be made. Mad Money host Jim Cramer, author of Jim Cramer’s Mad Money, shows you how to read the signs and buy, buy, buy.

The first dashboard instrument we have to check to determine whether we have a bottom at hand is market sentiment. Sentiment’s a tough thing to gauge. There are tons of anecdotal indicators and services that produce “bottom calls,” but I find them dubious because they tend to be without long-term significance. We are, in the end, measuring pain, and when the pain gets to the maximum, we are going to get a bottom, which was the case in all four of our mega bottoms of the last twenty years.

That said, here’s my sentiment/psychology checklist of what must occur before we can be sure that a bottom might be at hand. Until you see every one of these indicators, you would be nuts to commit any excess capital to the market. It would be akin to running outside of a bomb shelter during the London Blitz without waiting for the sirens.

First: The pain makes the front page of the New York Times. This indicator, one of the absolute favorites of Mrs. Cramer, has literally never been wrong. Such a simple thing, but is worth considering why it works so well. First, the supposition here is that during the periods of incredible pain there are always people who show up in the business sections of your newspaper, in the business magazine press, and, of course, on business TV, saying that a bottom is at hand. For the most part, those who say these things are pushing an agenda. They typically have liked the market for some time and didn’t get out, or they are always liking the market because it is good, at least short-term, for their business, whatever that business might be. Maybe they run a mutual fund and that fund can’t short. It’s therefore “always” a good time to invest in that firm. Maybe they run a brokerage business that makes its money in commissions and the worst thing that can happen is to say, “I wouldn’t buy now.” Given that most of the profits from equities come from writing buy tickets, chiefly of underwritings, where the sales fee is much bigger than anything that could be gotten on the sell side, the notion of trusting any of these people is simply preposterous.

Nor does it help to read in the business section of the New York Times or the green “Money” section of USA Today, the two most important papers when it comes to calling a bottom, that there is a lot of blood on the streets or that the pain is getting too great. Those are classic canards, too. In my research on bottoms I found dozens of articles about pain and losses in these sections that were written before some of the biggest parts of declines occurred. But all bearish bets are off when the New York Times or USA Today puts the market’s pain in a prominent place on the front page of their papers. Amazingly, at every bottom, stories about how horrid the market is have become a staple. If the market-woes stories aren’t on the front page, then simply wait; the bottom hasn’t been reached yet. There hasn’t been enough pain outside the little financial world to create a bottom. It is simply incredible how right this indicator always is. It’s so right that every time I have come up against a terrible bear market phase, and there have been a ton of them in the last twenty-five years, I find myself arguing with my wife about the possibility of a bottom, and she will casually ask me whether the Times has put the markets’ woes on page one. When the answer is no, stay on hold; you aren’t there yet. You will miss some transient bottoms for sure, but all mega bottoms meet this characteristic before rallying sharply and, largely, for good.

A second gauge of sentiment that has never been wrong and has snared all four of these mega bottoms is the Investors Intelligence survey of money managers. Again, like the New York Times indicator, it is a contraindicator, a counterintuitive sign that will make sense only after you understand the dynamics of the poll.

For twenty years, Investors Intelligence, a nationwide service, has questioned newsletter writers about whether they are bullish or bearish. While you might expect that a good time to invest is when the managers are bullish, that’s actually the worst time to invest. Anyone who answers the poll by saying he is bullish is admitting that he likes the market. If he likes the market, he is by definition already in and invested. It therefore stands to reason that if everybody’s bullish, then everyone’s spent his cash and bought his stock. Which is why the single most important sentiment indicator I follow after the front-page New York Times indicator is when a majority of money managers polled dislike the market. When the bull-bear ratio shows a definitive majority of bears or even a plurality of bears with less than 40 percent bulls, you are in the safety sentiment zone. Mind you, a reading alone of less than 40 percent bulls doesn’t per se mean a bottom. But remember this is a checklist, and this is one of the most important indicators to hold out for to be sure you are not getting a false reading. If you jump the gun and commit your reserves because you think the market’s bottomed and you aren’t there yet on this ratio, you will always be wrong. That level of certainty is rarely available in any other kind of gauge. For those unfamiliar with this indicator, it can be found among all of the indicators in the Investor’s Business Daily and is available every Thursday morning in the paper. Never buck it; doing so has cost me tens of millions of dollars. Why should you lose money after I have proven that the losses always occur when you anticipate the bull bear percentages too soon.

It is somewhat unfortunate that so many of my sentiment indicators take advantage of the wrong-way nature of so many market participants, but remember, when you are calling bottoms you have to believe that all hope is extinguished, and so therefore everyone who has to sell has already sold. That’s why I regard the third and one of the “meanest” indicators to be one of the best: mutual fund withdrawals. No important bottom is without these. No bottom is sustainable without mutual fund flows occurring steadily for at least two months. There can always be periods of one or two or even three weeks where you might get outflows related either to tax concerns or to unusual events that scare people. But consistent, repeated outflows of several months in duration accompany all the big bottoms. These numbers, available on Fridays through an organization call AMG, are almost always in the papers Saturday or Monday, so, again, we are not talking about esoteric hard-to-find data. If you haven’t seen big outflows, again, you aren’t there yet.

Perhaps the most esoteric of my sentiment indicators, and the only one that isn’t readily accessible in your local paper, is the fourth indicator: the VIX. The VIX, or volatility index, is a measure of stress in the system. It is a compilation of worry as defined by various ratios of puts and calls that gauge either complacency or panic. Panic signals the freak-out selling that always accompanies market bottoms. A reading above 40 in the VIX — a measure of pure panic in the marketplace — indicates a market bottom. In fact, anything above 35 can trigger a possible bottom, but +40 is a requirement that all four of our significant bottoms have met. Any reading below 30 indicates that the bottom can’t be trusted. One note of caution: The first reading above 35 isn’t going to be the last. If you have the luxury, my work says the third week of +40 readings is the safest time to buy.

ABOUT THE AUTHOR
James J. Cramer, author Jim Cramer’s Real Money (Copyright © 2005 by J. J. Cramer & Co.), is the cofounder of TheStreet.com, host of CNBC’s Mad Money, and “Bottom Line” columnist for New York magazine.

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