After an incredible bull market starting in 1995 Nasdaq Composite index topped in a spectacular manner in March 2000. 20 % corrections are normal for every bull market, but the 40% drop that happened from March to late May was far from being normal. Chances were that market already topped, but the actual confirmation came 4 months later when market finished its topping process and started breaking down into a pattern of lower-lows and lower-highs. Whoever held positions through the initial drop, expecting that prices will recover (and there were many of these kind), got his nerves tested when prices broke down again. Fortunes were made during 90s technological boom and fortunes were lost in the aftermath. This was a tough lesson for everyone who thought that stocks can only go straigth up.
We'll go step by step through every intermediate term bottom in 2000-03 bear. There were many fake rallies before market actually bottomed in fall 2002. Note that the real bull market rally actually began in March 2003, but the lowest low was made in October 2002. For the larger perspective let's provide the weekly chart of SPX. I'm not going to explain every char into details as they are all annotated, but only point out the main things to consider.
The first rally out of October 2000 intermediate bottom was weak from the beginning. Nasdaq could not rally for more than three straight days before a bunch of selling signalled distribution into a rally. After less than 4 weeks of feeble rally attempt, markets went into new lows.
In early April 2001, after 20% drop, volume increased on a down day and the next day price exploded higher. After two days of consolidation Nasdaq flashed a follow-through day (FTD), which is a big up day on increased volume after a correction. This is a buy signal as markets usually rally at least for a couple of weeks after FTD. However, this was only a second intermediate bottom after a top. A bull market of such magnitude should need much more downside to go. And so, after an initial rally, market starts to act choppy as every rally is met by sellers, eager to get lost of their shares. Two failed breakout attempts are enough to turn buy signal into a sell signal.
The next plunge was devastating as Nasdaq lost more than 35% in about three months. The next sign of bottoming action appeared in September 2001. Markets gapped down and volume increased dramatically on a narrow range candle. It took four more days to actually bottom, but a huge volume suggested that rally out of this bottom could be sustained for more than just a few weeks. Also, at the age of year and a half and 70% drop on Nasdaq, the bear was getting old an chances were that this may be the final bottom. A 9th day FTD confirmed this view. Additionaly, market started the first weeks of rally in a steady uptrend with occasional distribution days, which were immediatelly bought. All in all, without the benefit of hindsight, I would say this is the start of new bull market.
The signs of topping of this intermediate cycle emerged in early December 2001. Nasdaq broke into new highs on huge volume but immediatelly sold off. Now, there is a non-written rule in trading. If market gives us a positive clue (a big volume breakout) but the action is just the opposite (sell-off instead of a rally), these is extremely negative sign. After a classic double top market goes into a correction.
Now, at this point it was everyone's guess whether this is a pullback in an uptrend or a continuation of a bear market. The first argument for the latter case is that this intermediate term rally actually topped with a topping pattern. Intermediate tops in bull market are usually a sudden events that catch everybody by surprise and not an obvious topping process. Secondly, the depth of a correction is concerning. First pullback in a new bull market is usually a short term profit taking event, not taking more than 8-12% of downside to complete. A 19% correction at least signals that the bear might not be finished just yet. A rally attempt soon fizzles out, which is a final confirmation that the three month rally was merely an escape out of severely oversold condition. This case clearly demonstrates why it is so important for a trader to stay nimble no matter how good the market looks. A failed breakout is a signal to stop buying and trim stops. After a double top suspicion trader should be left with only a small part of portfolio invested. And after a confirmed top savvy trader should be in cash, just observing what the market is going to do next.
Anyway, the next stage in bear market was just as ferocious as the previous one. Nasdaq once again plunged almost 50% before next signs of bottoming started to appear. In August 2002 Nasdaq attemped a rally, which was weak from the beginning as there was no volume and no price momentum. Some suspicious FTDs would probably flash a buy signal, but this would be a false alarm.
Bear markets like to bottom in double bottom pattern, so every breakdown into new lows that is immediately reversed should be treated with causion. In October 2002 Nasdaq pierced the July lows and pretty soon index could not fall any further as volume increased. An extremely powerful FTD right off the bottom is a buy signal. In less than a week market rallied 10%, catching all shorters off guard. As rally extended further off course many traders thought that this is it. But we have seen this all-too-explosive rallies before and we know that they are often meant just to clear the bearish sentiment out of markets. Too high volatility is never a good sign as this means that too many traders are speculating about short term market action and there are not enough big investors that just stick to their position. This choppines continues in 2003 and bear obviously isn't over yet.
Before I get to the final chart of this rather long post I want to clear what I mean by "start of a new bull market". Bull markets start out of economic conditions that favor a prolongued rally, that can take indices 30-50% higher over a span of 3-5 months. These are conditions when big institutional investors, often referred to as "smart money", are satisified with their positions. They don't sell into the rally but rather support it by buying every single dip, not to let prices fall too much. Obviously, the rally out of October 2002 low was not such case. Deep corrections are a clear sign that bull hasn't started yet.
Now, the October 2002 actually turned out to be the final bear market bottom, but from my point of view the actual bull market started five month later. In March 2003 Nasdaq flashed two consecutive strong accumulation days, which could both be counted as FTDs. Some choppines was following as many traders obviously still weren't convinced that rally will continue. A break out of consolidation in April 2003 is a must-buy signal no matter what. And, finally, in the following weeks the rally acted as it should. A steady uptrend on solid volume and not much price volatility are two major properties of every bull rally. Occasional corrections should not frighten you as they are soon met by more buying. Prices quickly become extended and as soon as everyone figures out that a new bull has started, it is already too late to buy.
The 2000-03 bear market provides some far more important lessons that the 2007-09 bear. First, the is no way anybody could predict when a final bottom is in. The only thing that could be predicted are intermediate bottoms.
The second lessons is that these intermediate bottom should be bought. Why? Well, first, because you can never know whether this is the final bottom. And usually a well-defined FTD, even after intermediate bottom, will provide nice profit potential for the next month or two.
And a third lesson. Stay open to the possibility of a fake rally, no matter how bullish it might seem. And also, never ever go all in. If you are wrong, you can get killed in an instant. The best strategy is to start buying as close to the bottom as possible. Every next buy should be based on the profit of the previous one. As markets rally 20% or more, be cautious. If market gets choppy, stop buying and just observe your positions, how they react after pullbacks and on breakouts. If the rally is for real, you will make a lot of money in the following months even if you are only 50% invested. If the rally is fake, you will be glad you are not 100% invested or even on margin.
However, if spotting a bear market bottom just from the index action is so difficult, can there be a better way to do it? Can we search for additional clues that would give us an edge? The answer is: yes, we can. We'll take a look at this in the next part.
No comments:
Post a Comment