what comes after a double bottom?

A double bottom marks a significant reversal in market direction.   There are two possibilities:

–after a bear market, meaning a nine-month to year+-long market decline caused by a recession.  (This is not the situation we’re in now.)  The market typically bottoms six months or so in advance of what government statistics will eventually say was the low point for the economy.  It does so partly on valuation, partly because the first anecdotal signs that the worst is over are beginning to be seen.

The market then begins its typical sawtooth pattern of upward movement, forming what technicians call a channel.  This is an upward sloping corridor whose ceiling is formed by progressive market highs and whose floor is similarly formed by progressive lows.  Initially, the slope can be quite steep.  Day to day, the market makes progress by bouncing along between floor and ceiling.

–after a correction, meaning a decline of, say, 5% to 10% in market value that occurs over several weeks and which, in effect, adjust market values back from stretched to the upside to levels where potential buyers see the potential for reasonable gains over a twelve month period.  (This is our current situation, in my view.)

Generally speaking, the same upward channel forms.  But the slope may be very shallow.  In fact, until new, positive, economic information emerges, there may not be much of a slope at all, so that stocks move more sideways than up.  Nevertheless, in the case that the channel is almost completely horizontal, periodic successful testing of the bottom established at the end of the correction reinforces the idea that downside risk is limited.

double bottom

As regular readers may have discerned, I have a complicated view of the value of technical analysis, which is the attempt to derive useful investment information from studying the volume and price trends of individual securities and/or entire markets.

In the US of the 1920s, technical analysis was king.  That’s because there were no real standards for reporting of financial results by companies (some of which switched accounting standards the way most people do shirts to show themselves to the best advantage) at that time.  Nor were there legal bars to prevent syndicates of wealthy investors from creating artificial enthusiasm by manipulating individual names up and down in bucket shop fashion.  Basically, technical analysis was all there was.  In my view, subsequent legislation mandating minimum auditing and disclosure standards, and outlawing syndicate activity, have rendered much technical work obsolete.

By the way, I also find much of technical analysis to be useless/incomprehensible.  Take head-and-shoulders movements as an example   …or the Dow Theory.  But my main objection remains that technical analysis is a century-old tool that has been superceded by fundamental analysis of audited and SEC reported financial results.  It’s like riding a bicycle in a NASCAR race.

Nevertheless, even fundamental analysts fall back on technicals in times of panic, which is, after all, completely about sentiment with no room in fear-gripped minds for fundamentals.  And there are a few indicators that I think are very helpful in gauging sentiment.

One of these is a double (sometimes triple) bottom.

what a double bottom is

The idea is to figure out the index level where selling that is driving down a market/stock either exhausts itself or meets potentially strong resistance from buyers.

bottom occurs when downward movement stops and reverses itself.  Often this happens on higher than normal volume.  Sometimes the final down period is marked by a steeper than normal decline.  The level of the low may also be closely related to a prior significant low.  At times, however, none of these confirming signals are present.  The important thing is that the marke/stock stops falling and begins rising again.

Four to six weeks later–not any sooner, but occasionally even later than six weeks–the market/stock stops rising and declines again to the vicinity of the prior low.  If the market/stock then reverses course and begins rising a second time, it is said to have tested and confirmed the prior low.  In most cases, this double bottom signals the end to the down phase.

Sometimes, the market repeats this process and forms a triple bottom.

 

From a psychological point of view, the fact that the market/stock falls to a significant low but repeatedly fails to break through that low creates and strengthens the belief that this is a point where significant resistance to further decline will occur.  The more the low is successfully tested, the stronger this conviction grows.

relevance for now?

The S&P 500 made a low of 1867 on August 25th.  This is very close to the closing low of 1862 (intraday:  1820) on October 15, 2014–and another low (1816) on April 11, 2014.  The index reversed course on all these occasions, this time reaching 2020 on September 17th.  The S&P then declined to 1882 on September 28th.  The market then reversed course again and has been rising since.

So far this looks like a classic double bottom–the first low, the four-week interval, the confirmation of the first low, all linked to prior significant lows.  We’ll only know for sure as we see trading unfold over the next few weeks.

In the present case, the formation of a firm bottom for the market would also be evidence in favor of the idea that investors are willing to separate clearly the (weak) commodities-related sectors from the (strong) rest of the market and are not prone to let the former infect the latter.

 

 

technical analysis: double bottom

Regular readers will know that I’m not a particular fan of technical analysis, at least as a primary tool in determining the investment attractiveness of the equity market or of individual stocks.  A hundred years ago–maybe even sixty years ago–it was the tool, because there was nothing else.  Before the SEC, company financials were a joke, and they weren’t easily available in a timely manner.  Watching the trading patterns of the “smart money” was arguably the best an average person could do.

Nowadays, the SEC’s Edgar site has all US-traded companies’ filings available for free the instant they’re made.  Most companies also have extensive libraries of their own available on their sites.  Firms now webcast their earnings conference calls for all to hear.  If you don’t feel like listening, transcripts are available for free soon afterward from Seeking Alpha.  

So it isn’t so much that technical analysis is bad per se.  It’s just that like the horse-drawn cart it’s been replaced by fundamental information that’s quantum leaps better.

support/resistance

Still, there are some aspects to technical analysis that I find useful.  One is support/resistance.  This is the idea that price levels where there has been significant past trading volume, preferably over an extended period, will act as floors to support stocks as they fall, as well as ceilings to impede their advance.  Both holding at and breaking through these levels are often significant events.  In particular…

double bottom

When the market has been declining for an extended period of time, or has dropped particularly sharply (the “magic” numbers technicians use are typically losses of 1/3, 1/2 or 2/3 of the prior advance), it often stabilizes for no apparent reason and begins a significant upward bounce (+10%?).

The fact that prices are now going up isn’t enough by itself to establish they have reached an important low.  In almost all cases (March 2009 was, on the surface at least, a significant exception–see below), stocks begin falling again within a few weeks and find themselves approaching the previous low.  If the market touches–or almost touches–the previous low but begins to rebound again (in the US, the market may briefly trade lower than the previous low–we’re daredevils, after all), this is often a strong sign that resistance is forming at the old low.  This revisiting of the low is the necessary second part of the double bottom.

There can be a triple bottom, too.  More often, in my experience, the market begins a new, upward pattern of higher highs and higher lows after the second bottom.

Fundamental conditions must also be in place for this bottoming to happen.  Stocks have to be cheap; investor pessimism must be high; the downtrend must be protracted enough for at least some investors to think that conditions won’t get worse.

In essence, what the double bottom tells us is that intense negative emotion that has been driving prices sharply (often irrationally) lower has begun to play itself out.

current examples

Double bottoms happen with individual stocks and stock groups, too.

Look at the Macau casinos traded in Hong Kong.  Some, like Galaxy Entertainment, have lost half their value over the past ten months.  But the group appears to have bottomed in late September-early October.   The stocks bounced off their lows, returned near them several weeks later and appear since then to have established a new upward pattern.

I haven’t looked carefully at energy stocks–but the oils are a group where I’d be looking for similar behavior.

the March 2009 case

The S&P 500 appeared to me to be bottoming in early 2009.  As is usual during recessions, government programs were being put in place to stop the economic bleeding.  Anticipating this, investors had pretty much stopped selling.  However, in late March investors were horrified to hear that Congress failed to pass the proposed bank bailout bill/  Some (Republican) Representatives were even saying they would prefer a rerun of the Great Depression to a bank bailout.  The S&P fell more than 7% on the news, but recovered all its losses when the bill was passed the following day.  If we erase those two trading days, early 2009 exhibits a “normal” bottoming process.