How To Spot A Bear Market Bottom, Part 1: Bull Market Top

I decided I'll make a series of posts on how to spot a bear market bottom. When bull markets top a trader has only two choices. He can try to short indices or individual stocks or sit on cash and wait for a bottom. A third option, riding a bear market all the way down is not acceptable and should not be exercised. In any case, spotting a bear market bottom is an opportunity that must not be missed. Markets are made to trick most of people. And most people won't catch an exact bottom. The ones who do, however, will make fortunes in the first and usually most powerful phase of a new bull market.

In this part we shall look at the first stage of a bear market which is a bull market top. The last two major bull market tops occured in 2000 and 2007. Both annotated charts are shown below.


Now, there are a couple of things to notice here. First and most important: a market top is a process, not a one-time event. Major tops take months to develop. 20% corrections are normal occurences and they don't necesserily mean that a new bear market has started. However, deeper corrections might suggest that market has already topped, as happened in Nasdaq 2000 top, which was the special case of a climax top. So shorting too early, anticipating a bear market, might be very bad for your portfolio.

The second thing to notice is that bull market usually tops when, after 15-20% correction, it cannot rally into new highs and keep the breakout. 2007 top is a classic example of this as market made a double top right above the breakout point and then collapsed.

Bear market is confirmed when the pattern of lower lows-lower highs starts to emerge. As long as uptrend line is valid, we cannot be sure that this is really a start of a bear market and not just an intermediate correction.

Now, let's see how this applies to the current market conditions. First, the length of topping process. Both 2000 and 2007 top took almost exactly five months to develop. History often repeats itself and so it did this time. How long did 2011 top take? Exactly five months.

The topping pattern was a classic head-and-shoulders. After marginal breakout to new highs in late April 2011, market soon dropped for another correction, which tested prior lows. After that a fakeout rally formed a right shoulder before neckline finally gave way and a pattern of lower highs-lower lows confirmed the start of a new bear market.

As we shall see in following parts, bear markets don't bottom that easy. It usually takes several fake rallies, which fool majority of traders, before market, when everybody throw in the towel, finally bottoms, leaving most traders behind. The main point of this post is to show some evidence why I think this bear market is far from bottoming. We have only witnessed the first stage after a top, which should be followed by at least two nasty drops. More on bear market stages is following.