The Bottoming Process

If you’re a growth investor, you’re probably pretty unhappy right now. The NASDAQ composite, and the phenomenal performers from last year, have all been re-evaluated from historical fundamental standards and have only left skid marks where previous highs did reside. The contraction of valuations has left no growth stone unturned.
If you’re watching CNBC, you are seeing most analysts in agreement that growth stocks have not been this valuable from a fundamental standpoint since 1994. However, you are currently working thru a great deal of downside momentum that has yet to be turned. Let’s take a look at what to look for as the market, in this case the NASDAQ, goes thru a bottoming process.

I. You want to see significant volatility in the market – In this process, you want to see the trading and the stock action flying all over the place. I can assure you that volatility is on the rise. In fact, one measure of volatility, the CBOE Volatility index has been on a steady incline since August of this year. It’s current indication is painful, but a very good sign.

II. You want to see quality fall – An investor doesn’t have to look much past growth issues like Cisco, America Online, EMC, Sun Microsystems, Siebel Systems and Ciena to realize that the quality issues are now falling. This is what you want. You want investors getting frustrated, vomiting from the volatility and “throwing in the towel” on the quality. To this point, these stocks have been holding up relatively well and only in the last ten trading sessions have they truly begun to sell off.

III. You want to see negative sentiment – Typically, the street is wrong. This is the basis behind sentiment indicators. If everybody on the street is saying we’re going lower, you’re probably ready to go higher. Think about it this way. The people who are bullish are typically 80-90% invested. Therefore, if the masses are bullish, there is probably not enough money or interest on the sidelines to push the market higher. The Put/Call Ratio is our main sentiment indicator. Right now, the indicator is very bearish (i.e. there are more bears than bulls). This is a positive indication if you’re looking for a bottom.

IV. You want to see capitulation – The bottom will usually be completed by one “blow off” day. This particular day will see heavy selling in the morning followed by heavy buying during the afternoon. This is the day where investors say, “enough is enough” and begin scooping up valuable shares. We haven’t seen this day yet.

Keep in mind that it is very easy to doubt yourself during this correction. The fact is that stock market corrections are normal and usually expected every four or five years. If you think about it, we haven’t had a bad year in the market since 1994. It is all too easy to change your investment philosophy and discipline in a tumultuous market. That’s the last thing you should do. You start selling the strong issues out of your portfolio only to be whipsawed and befuddled when the market turns up. Stick to your guns and look for the long-term. We are still in a very good economy and earnings are what drive the market.