A previous article covered the structure of stock bubble tops and pops. Here we discuss the opposite situation, the bottoming of price that occur in the bear markets after the stock bubble has popped.
Psychology of stock market bottoms
Let’s start by discussing the psychology that occurs at the bottom of a bear market.
- Just the same as stock bubble tops, it is very difficult to know that stock prices are bottoming while it is occurring. It is something that is only obvious in retrospect.
- When good news occurs, it is often ignored and has minimal effect on the price of the asset.
- The mainstream media reporting is either negative or absent regarding the stock. In the early stages of a bear market, when the stock bubble first pops, the mainstream media tend to report the dramatic drop in stock prices. This is followed by a quiet period. In the final stages, reporting is often strongly negative, with proclamations that the particular asset class is dead.
- Retail investors are completely uninterested in the stock. Anyone who tries to call the bottom and express any hope of prices rising is mercilessly berated.
- The smart money is quietly buying and accumulating the stock during the bottoming period.
This all sounds very straightforward and although we are all capable of spotting these signs, the problem the subjectivity of these signs. Additionally, these signs all appear over time, not at a single time point. It is therefore difficult to use these signs to determine the exact time that prices will turn around.
Emotions during a bear market
The chart above shows some of the emotions that occur as stock prices drop during a bear market. This is something that all of us will have experienced at some point. A 5% drop would be considered a normal pullback and even a drop of 10% is seen as just a healthy pullback or correction. As prices drop further, the “buy the dip mentality” kicks in. Common phrases include “all stocks are on sale” and “this is a good time to buy”. Prices might then move sideways for a while and then when a 20% drop in prices occurs, there are expectations that a turn around is due. Once you get below that 20% level (an interesting psychological level in the stock markets), that is when investors really do start to worry. With a 30%, the strategy turns to longer-term investment, “oh I won’t touch this for 15 years, this stock is bound to go up and I will recoup my gains”. But prices continue to drop. After a steep drop of around 40% the investor throws in the towel and says “I’m out”. As price drop further, there is a sense of relief, “I’m so glad that I sold”. As prices drop even further, that is when investors really give up and say “I’ve had enough, I’m not investing in this at all. I’m never coming back to this market”.
Chart reversal patterns
Chart patterns is another potential way of determining the bottom of a bear market. The problem is that there are lots of possible reversal patterns, with the potential of pattern failure which can occur as the bear market is progressing. The common types of chart patterns that signify a trend reversal include double or triple bottoms, inverse head and shoulders, rounded bottom, or different types of triangles. Therefore, using chart patterns to determine a trend reversal can be very difficult.
Four phases of an asset bubble
The chart above shows the four phases of an asset bubble. Here we will concentrate on the blow-off phase and the stealth phase. Note the gray dotted line which is the mean price. During the stealth phase, prices stay close to the mean price just before prices take off. After the capitulation event during the blow off phase there is an overshoot below the mean, before prices revert back to the mean and start moving up. This overshoot below the mean is the location of the stock price bottom.
Examples of stock bottoms
NASDAQ index bottom
The Nasdaq chart on the monthly scale shows the dot-com bubble of 2000. Isn’t it interesting how this chart looks very similar to the theoretical asset bubble chart? The trend line joins the lows before the take-off in price and this seems to be a good support and resistance level. After the bubble popped there was a small bear market rally, followed by the capitulation stage with the despair overshoot below the trendline (mean price). Prices subsequently continued to rise to resume a new bull market.
If we look a bit more closely at the NASDAQ chart on the weekly scale the mean trend line initially acted as support but that subsequently broke, leading to the despair overshoot. The mean trend line became resistance which was tested three times before breaking, and price began its upward move. There is no obvious reversal chart pattern. Although it could be interpreted as an inverse head and shoulders patter, it is somewhat lopsided. Picking the exact bottom here would have been difficult at that time.
Multiple bitcoin bubbles
Bitcoin has experienced multiple bubbles in its 10-year history. One such bubble occurred in 2013. The trend line has been drawn where just before the price took off. Interestingly, this chart shows two bottoms after the bubble popped. There is no obvious pattern to these bottoms and at the time there would not have been any easy indication that prices were going to turn around at those points. Could we have drawn the mean trendline prospectively? The price action preceding the bubble is curved, making drawing a trendline and determining the take off point very subjective.
Moving forwards in time, the chart above shows the bitcoin price action from the after the 2013 bubble, to form the 2014 bubble. The trendline joins the two lows before prices took off. The despair overshoot was brief and occurred in 2015. Note that even if you had picked that exact bottom in price, you would have had to wait over nine months before getting confirmation that was indeed the bottom, and the bear market ended.
Shanghai composite index bubble
The Shanghai Composite Index became a bubble in 2007. The mean line joins those previous lows before prices took off in 2006. Interestingly, this chart shows similarities to the 2013 Bitcoin bubble chart, with two bottoms in price and the despair overshoot did not occur initially. There is no clear cut reversal chart pattern.
Silver price bubbles
Silver has experienced two bubbles in the last 45 years. This chart illustrates just how difficult is to call a bottom. In the 1970s, the mean line was drawn by joining the lows before price went parabolic. The despair overshoot did indeed occur but after price recovered in 1983, again re-entered the despair zone. Rather than entering a new bull market, silver price was crushed to lower and lower levels and price moved sideways for over 15 years. When the silver price finally did recover, it recovered in spectacular fashion. As mentioned, drawing the mean trend lines before price takes off can be rather subjective. If the mean line for the 2011 silver bubble is drawn correctly, it does look like it is in the despair overshoot, suggesting a recovery could be around the corner.
The take-home message is that stock price bottoms are highly variable and difficult to identify. Bottoming is a process rather than a single point in time and can often take a lot longer to play out than the parabolic pointed tops that observed in stock bubbles. Looking for despair overshoots below the mean trend line might be helpful in terms of avoiding buying before the drop has fully played out. However, this wont help in terms of timing when the upswing will start and as we have seen, that can take some time. The key here is patience.
Finally, it is important to distinguish between a stock that is bottoming from a stock that is going bankrupt. When prices plummet there is no guarantee of recovery. For example, at the height of the tulip mania in 1636 the best tulips cost more than houses. After prices collapsed tulip prices never came even close to that price level. This is where it is really important to understand the fundamentals of the particular asset and look at the potential catalyst that might lift prices.