Welcome to Finance and Fury. How do you know the market is at its bottom?

  1. In truth, you never do – most of the time it comes down to luck as to whether you buy in at exactly the right time
    1. Remember that the price of the market can move more than a percent in a day – as we have seen recently – there is no way to pick the exact bottom – but are there signs that the market is bottoming out? Or at the very least oversold?
  2. There are – so in this episode we will look at a few key indicators on how to tell that a financial market has been oversold – and when compared to the potential price of the market in 5 to 10 years’ time – are in the bargain territory
  3. Big disclaimer – This episode is just general information – These indicators don’t mean that markets can’t keep declining – they have just historically been a reference point to when the share market has been bottoming out
    1. You should not make any investment decisions purely around this information and should seek professional advice and take into account your own personal situation before making any decisions

To start with – lets break down the very basics of markets price movement – being the supply and demand of an asset

  1. In regards to shares – this is mostly demand in the short term – in the long term, additional supply of shares can change in the market – just look at shares like NAB – massively increased their supply of shares over the years to help with their Tier 1 capital – on the other hand other companies like Qantas – did major share buy backs – over an extended period, this had affected both companies – prior to 2020 – Qantas shares rose in price – NAB hasn’t materially changed in price since 2005
  2. However – the thing that really affects prices in the short term – hence creating major swings in volatility – is the demand for shares – are investors wanting to sell or buy a security – the more that there is an inclination to sell – the further the bottom becomes for an asset
  3. Next – we need to look at the difference between the behaviours of a top and bottom of a market –
    1. These levels can often be referred to as support and resistance levels
      1. Support – is where the price regularly stops falling and bounces back up – it is a bottom of the market – in the short term at least – where the amount of demand of an asset becomes strong and causes the prices to recover
      2. Resistance – is where the price normally stops rising and dips back down – This is the top of the price range, as demand wavers and profit taking comes into the picture
    2. These two are the floor and sealing levels of the markets – but sometimes you see a breakout in both and new highs or lows are reached – so these levels are never set in stone – which makes it hard to know when a true level of top or bottom has been reached
      1. Markets reaching their tops are processes – as new tops are always reached as markets continue an upwards trend – Tops can play out over many months due to the nature of demand on the upside
      2. However – market bottoms tend to be points in time – new bottoms are rarely reached – due the nature of market growth – we recently had a 40% decline in the market in 2020, but this 40% decline was nowhere near reaching the same bottom that came about due to the 40% decline in the GFC – this is where bottoms are often sharp and sudden and the rally afterwards can be as aggressive as the initial sell off – but it is rare if not almost impossible to reach a record low, unlike record highs
    3. Catching a market bottom can therefore be very profitable in the short term if you get the timing right – which can mostly come down to luck – but there are some signs that the market is in the oversold territory – pointing to a time to go bargain hunting – whilst it may not be the bottom – if your strategy is to buy and hold – it can be very profitable over the medium to long term

Indicators to look at when markets are looking oversold – look at four – there are many more to look at beyond these – such as technical indicators – but we will look at 4 key ones

  1. First – we have the number of new highs minus new lows – This is where you take the number of shares on the market making new 52-week highs and minus those making new 52-week lows
    1. Why does this matter? The market is the index – which is every share listed on the market – a common misconception is that if the market is going up or down, that every share is moving in unison – often, it can just be a handful of shares that are moving in a certain direction that moves a market – whilst other shares listed may be moving in an opposite direction
      1. This is where some shares matter more than others on the index – market caps and weightings – Apple at $2.6T matters much more than 3M at $82B – still a massive company – but the total of number of shares on the index still matter
      2. But when most shares on the index have reached a new 52 week low – this is a sign that the market is entering into an oversold territory – as it is a mass selloff in the market
  • It is important to remember that why markets decline can be for any number of reasons – we are seeing interest rate increases, inflation concerns and geopolitical events as the primary cause of concern at the moment – but some companies on the index will likely not be affected by these in a macroeconomic sense – so if these sorts of companies hit their 52 week lows, this can be a sign that the market is just being oversold
  1. Looking at some historical data over the past 10 years – there have been 3 times when the new 52-week highs minus those making new 52-week lows exceeded -300 – each of those coincide with a bottoming out of the market – through a drop of more than 10% from the previous price
    1. 2016 – markets dropped around 10% – but the highs minus the lows was sitting at a negative 650 – so 650 more shares were at their 52 week low
    2. 2018 – from Aug 2018 to Dec 2018 markets dropped 10% on average – the highs minus the lows also dropped to -500
  • 2020 – the markets dropped a massive amount – 40% pretty quickly – the highs minus the lows was sitting at -900
  1. Where do we currently stand – only at about -200 – so there is the potential for further downturns in the market based around this single metric – but it does show that we are starting to enter into the oversold territory – we might just not be at the very bottom yet
  1. Second – Look at sentiment in the index and treat this as a contrarian indicator – there is the old adage of “be fearful when others are greedy and greedy when others are fearful”
    1. One method of tracking this is the feed vs greed index – another is the Bull vs Bear Sentiment spread
    2. These measures show how the average investor feels about the current state of the market – this sort of index works well when looking at a contrarian measure – as when people are fearful, they have likely sold their holdings – obviously if everyone has sold their holdings, it means that the price can be bottoming out
    3. Where this is currently sitting is near the bottom range of a -30 between the bull and the bears – it has hit this level three other times over the past 10 years – this was in 2016, 2018 and 2020 – lone and behold this is similar to the first metric we looked at – so by this sentiment index alone, the market can look oversold
  2. Third – we have the VXV/VIX ratio – This is a ratio that compares two time periods of volatility within a market – both in the short term – but one being over a 3-month timeframe and the other being 1 month
    1. All that you do is take the 3 months volatility index, and divide it by the 1-month index measure
    2. When it is high or increasing it implies complacency in the market as longer-term volatility is rising but short-term volatility is relatively low – in other words, the higher the number, the more the market is likely to be on a bull run
    3. But when this ratio is falling – it points to higher levels of volatility in the here and now – often resulting in major downturns – The VXV/VIX ratio has recently been falling, but remains much higher than at previous significant market bottoms – looking at the historical data – in the past 10 years there have been 4 times that this ratio dropped below 1 – that was in 2016, 2018/2019 and 2020 – We have just cracked the ratio of 1 at the moment – but it does still have a little way to go from the previous lows of 0.9 in 2016, 2018 and close to 0.8 in 2020
    4. The VIX index alone at its current level is showing a somewhat bullish sign – On its own, the VIX doesn’t mark the bottom of anything, but it is a good indicator to see that fear is reaching some extremes – but when taken in conjunction with the VXV index, we seem to be reaching the bargain buying opportunity
  3. Fourth – Look at the number of shares in advance vs declines, in other words, the cumulative number of shares on the market advancing minus those declining on a daily basis.
    1. This is similar to the measure of those shares that are in a 52-week high versus low – it shows the total measure of shares on the market that are behaving in a certain direction – either most shares are going up, or most shares are going down
    2. Where we are currently sitting – this has been falling but is not yet at a level associated with the late 2018 and 2020 lows – but we are getting close
      1. In 2016 – this reached -1,500 – in 2019 – this reached -2,000 – in 2020 – this reached -3,000 – where we currently sit is close to -1,500 – so it is showing that the share market is in a decline but may not yet be at an extreme level – similar level to that of 2016 but it may have a little way to drop from here – to similar levels of 2018 or 2020

In summary – Based around these metrics solely – it can be expected that there may be more volatility and potentially some further downsides in share markets from here – compared the past 10 years, many of these metrics haven’t hit the same levels that they did in 2016, 2018 and 2020 – but we are getting close

Remember that these tactical equity indicators are not a crystal ball, but do help to compare over sold markets of the past to where the market is currently sitting – these were

  1. the number of new highs minus new lows
  2. Look at sentiment in the index and treat this as a contrarian indicator
  3. the VXV/VIX ratio – reaching around 0.9 or 0.8
  4. Look at the number of shares in advance vs declines – reaching -2,000 or beyond

In the current market cycle, the market is trying to find a bottom, but we may not be there yet – however I am still investing in this current market – as assets are cheaper today than they were 6 months ago – so if I was investing then, why not do it today?

Some of the biggest things to remember if you are investing – is to make sure that you have enough cash to cover any emergency expenses – invest wisely, not through taking a punt on one individual share but a basket of shares through an ETF or managed fund to get diversification and remember that investing is for the long haul – it shouldn’t be viewed as a short term endeavour – the current stage of the market cycle should just be viewed as a buying opportunity for the long term, not trying to guess what will happen in the next 3 months and capitalise off that – as there is no way to tell for sure  

People who have been investing for a while know that a turnaround will come – it can still be hard to weather the storm psychologically – but this is the nature of investing for growth – any reward comes with it a risk

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