Looking for Early Signs of a Stock Market Bottom? Here’s What to Watch For

red arrow crash through ground

Before I get into the meat of my article today, about signs of a stock market bottom, I just wanted to touch on one of the things I mentioned in my last write-up that I’m seeing a lot of in recent days—the fact that, in a bad market, good-looking stocks can go bad in a hurry.

The reason for this is simple: During downtrends, big investors are looking to unload/reposition their portfolios, so they take advantage of strength to pare back. And they especially like to sell soon after obvious breakouts, where there’s usually a good amount of liquidity (plenty of people buying the breakout, etc.), allowing them to sell more shares in a short period of time.

Take MongoDB (MDB), for example, a stock I spent a few paragraphs writing about in last Wednesday’s issue of Cabot Growth Investor. The firm’s new-ish story, excellent fundamental growth and the stock’s resilience during the October decline pointed to it being a possible leader of the next advance. Sure enough, after a huge market rally last Wednesday (November 7), MDB was positioned near all-time highs!

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But look what happened starting on Thursday of last week: MDB toyed with a breakout that day before closing lower on above-average volume. And the next two days the stock fell sharply on big volume—while there is support in the low 60s, MDB’s chart now looks double toppy, which isn’t a good look.

This isn’t to pick on MDB—just about every growth-oriented or cyclical stock that’s attempted to move to new highs has been smacked back by the market recently. The overall point is that, until we get a confirmed uptrend from our Cabot Tides (intermediate-term trend) and Cabot Trend Lines (longer-term trend), it’s likely we’ll see lots of this type of action. That’s why having plenty of cash makes sense, and if you do want to buy, keep positions small (no more than half your normal position size) and adhere to some strict loss limits.

Whenever this correction finishes up, the more resilient growth stocks will have a great chance of going on big runs. In the meantime it’s about remaining patient and continuing to add (and subtract) names from your watch list, while keeping buying limited.

Three Signs of a Stock Market Bottom

Moving on, I’ve been getting a bunch of questions about this, that or the other market indicator and what it means in terms of the market’s correction. Honestly, the longer I’m at this game, the more I like to keep things simple. (I literally have a sticky note on my office wall that says, “Be Dumber.”) Thus, for my part, I’m watching my trend-following indicators mentioned above, my Real Money Index (which tracks money flows into and out of equity funds) and the action of leading growth stocks for signs the sellers are out of ammo.

But what about some other secondary measures that could help identify a stock market bottom? Here are three things I’m watching that could provide some early clues to a change in the market’s negative character.

Small Caps vs. Defensive Stocks

When talking about secondary measures of the market, I’ve grown increasingly fond of indicators that track the relative performance of growth stocks vs. defensive/safe stocks—a marked change in relative performance effectively tells you of a character change among big investors.

I haven’t come up with specific buy and sell signals, but I do find value in looking at the relative performance of the S&P 600 Small Cap Index (SML), representing growth stocks, to the Consumer Staples SPDR Fund (XLP), representing defensive stocks—in the chart shown here, up means the S&P 600 (growth stocks) are outperforming, while down means the XLP (defensive stocks) are getting money.

The action in small caps vs. consumer staples is one measure of a stock market bottom.

You can see what’s been going on since September—a steep downtrend as defensive stocks have been in favor. And even during the recent bounce, the RP line couldn’t get off its knees. I’d like to at least see the line get back above its 50-day average (blue line in the chart) going forward, a sign that growth stocks are attracting money once again.

Divergences in New Lows, Momentum

The market usually sees lessening downside momentum before it bottoms out—that plays along with market bottoms being a process, not an event, which I touched upon in my last column. Two of my favorite ways to see if momentum is waning are to watch the number of stocks hitting new lows and the percent of S&P 500 stocks above their 200-day lines.

Should the major indexes approach their October lows, I’d like to see the number of stocks hitting new lows on the NYSE (around 525) and Nasdaq (near 560) come in far fewer than their respective maximums in October.

It’s a similar story for the percent of stocks on the S&P 500 above their 200-day line—it got down to 34% or so during the worst of the October selloff. If the major indexes retest those lows, a higher reading would be a ray of light.

Institutional Investor Sentiment

As far as sentiment measures go (which tend to be inexact), I prefer ones that measure real money flows, like my aptly named Real Money Index (written about in every issue of Cabot Growth Investor). Another one that’s updated weekly comes from the National Association of Active Investment Managers, or NAAIM for short, which measures the average exposure to U.S. equity markets by its members.

Shown here is the chart of the NAAIM Index during the past few years (along with a five-week moving average to smooth out the ups and downs). You can see that the past few weeks of readings (and the five-week average) have fallen to levels seen at market lows from earlier this year—but they’re nowhere near the washed-out levels witnessed during the bottom of the mini-bear market of 2015-2016.

Interestingly, this week, the figure dipped to just 35%, a good sign that we may be seeing some throw-in-the-towel action from money managers. (Not shown on the chart as it hasn’t updated yet.) But it would be good to see the five-week measure dip further, especially if the major indexes retest their October lows.

Again, nothing beats the bread-and-butter indicators like the trends of the major indexes and potential leading stocks, but these handful of stock market bottom measures are something to keep an eye on for some early reads as to whether the market might be ready for more than a meager bounce.

Michael Cintolo

Your Guide to Winning Growth Stocks

Michael Cintolo is a growth stock and market timing expert. His Cabot Growth Investor, with its legendary Model Portfolio, is recommended for all investors seeking to grow their wealth.

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