How to spot a market bottom
“People haven’t capitulated yet. I want to buy in once people capitulate.” - my friend
Being able to buy in at the bottom requires three things:
You’re able to stay cool under pressure. Max unemotional during max turmoil type of cool
You still have money left to spend because you haven’t been sucked into all the previous false bottoms
Understanding what a bottom looks like
[This email isn’t investment advice and I’m not an investment advisor.]
Part of staying cool under pressure and preserving money for real bottoms is increasing your knowledge of what bottoms look like.
Last time I wrote you (3 weeks ago) I proposed that equity (tech) had oversold near-term and might see a bear market rally. We did, but not before the market went down for another week, hitting a relative strength of 20 (oversold territory is under 20), then recently rallied. This is the issue with even calling near-term bottoms: things can get worse than we think, and often do.
So what’s the problem with going down a bit more. After all, if we are down 80%, isn’t that a good time to buy?
The difference between down 80% and down 90% is down 50%.
Let that sink in. Do the math.
That’s why pro investors are shy about buying at the bottom and call it “catching a falling knife”
But not thinking about bottoms, not doing the research isn’t the answer either.
In this blog, I’ll cover:
Capitulation - everyone but me will do it
Bear market rallies - fun and dangerous
Maggots under rocks - bears reveal scams
Capitulation - everyone but me will do it
As long as we are actively looking for capitulation, we are, by definition, not there yet.
March 2020.
I was trying to cover my short at the bottom and Knight Capital Group (20% of NASDAQ volume) froze up. I couldn’t get a simple (small) trade executed through Fidelity (which was using Knight’s dark pools to execute my trade, apparently). Even for me, this was not the day I backed up the truck to buy, but it should have been
When you can’t execute a trade because 20% of the market’s computers have frozen up, and in my case the trade took 2 hours to execute vs normal milliseconds, this doesn’t instill confidence.
Looking back, we say, yes nothing actually went wrong, but in the moment it’s scary.
That reminds me of 1987…
Yup, been around that long… I was a teenager then, investing in the market with my dad
Black Monday, October 29, 1987 the markets go down 20%. Stock brokers were jumping out skyrise windows committing suicide. There were simply no bids. The market went dark.
That evening I asked my dad if he was going to buy now that everything was 20% cheaper.
No, he said, he wanted to see how it traded over the next days and weeks. Very reasonable considering that the markets were expensive and down 20% might just be the start. On the other hand, down 20% in one day is near-term oversold.
The market drifted down a bit more the next day and ended the year higher, leading to a multi-year rally.
In 2000, I was at a hedge fund and was fortunate to have sold at the top.
But we got hurt trying to find the bottom. Every time the Fed lowered rates, markets would look more positive, we’d buy in, and get our head handed to us. Over and over.
Finally, after we had closed the firm (March 2003), the market found a bottom in the summer of 2003, where tech stocks were trading for less than the cash they had on the books.
That’s capitulation.
In 2008, we had quite a year.
Starting with Bear Stears nearly failing before it got bought, then AIG, Fannie Mae and Freddie Mac getting rescued, and then the massive government experiment…
What would happen if we didn’t rescue Lehman?
The government worried about creating moral hazard, that they had rescued so many (in August alone AIG, Fannie and Freddie) that companies would start thinking they could go nuts on risks because if anything went wrong, the government would rescue big firms.
So grow big and take big risks paid off. Until it didn’t.
Lehman had tendrils worldwide. US bankruptcy didn’t synch with laws in other countries, in other Lehman offices. And then there were all the derivatives, counterparties, etc. That bankruptcy sent markets into one massive seizure.
A few weeks later we were at market bottom valuations. Was that the bottom? Yes and no.
The Lehman bankruptcy and housing crisis had inflicted mortal wounds on many large companies, especially banks which had books full of bad loans.
The mantra around investing circles was “Solvency vs Liquidity”
People worried that even if the banks were open for business, if they looked at the true value of the loans on their books, their liabilities were far greater than their assets, so nearly all the US banks should be bankrupt.
Markets rallied off the valuation bottom (and oversold situation post Lehman) for 4-5 months, and then the narrative of bankrupt banks took over.
It was powerful because it was true.
So the government said: “Fake it till you make it, baby!” And we were home free!
FASB (Financial Accounting Standards Board) which opines on accounting standards issued a ruling that allowed banks to not mark their loans to market for a while, buying them time to grow out of the problem. Did I buy right then? Hmmm I was worried that this was window dressing, so I waited.
This is the problem with bottoms, they really feel terrible when you’re in them. So you capitulated right along with the rest.
For the 8 years I traded them, from 1995 through 2003, I did have repeated luck buying semiconductor stocks at the bottom and selling at the top, but that was a smaller industry, so I could narrow in on several indicators for the top and the bottom. I was still one of a rare few that could do this with success, but I think it’s still easier than markets which are more diverse in nature.
Still, difficulty shouldn’t mean we give up trying to learn about market bottoms.
Bear market rallies - fun and dangerous
One week after (and quite a bit of downside more) I wrote you, the RSI hit 20, which was truly oversold (I think it was 24 when I wrote). RSI is relative strength indicator, and 20 is very weak, meaning investors are running scared.
Here’s what happened next:
caption for image
This could have marked the bottom, but more likely, what we are in is a bear market rally.
They suck more people in, but can represent 30-40% rallies, so real money can be made, and subsequently lost… remember the down 80% vs down 90%.
To get some perspective, take a look at the last year:
caption for image
On the one hand, that’s a big decline, and the rally we have had in the last two weeks looks small in comparison.
This is why bear market rallies typically go up 30-40% before rolling over and taking us down to lower lows.
Fundamentally buyers in bear markets are value buyers, and their price points are multiples lower than growth buyers.
But people are driven by crowd psychology. Too much FUD and traders will nibble, thinking others will do the same, driving a bear market rally. But then there’s not enough real growth or momentum to let growth buyers buy in size, so they trim when they’ve made 20-30% off their smaller trading bet.
And the value buyers price is still much lower.
Thus the bear market rally rolls over, and we head back into a bear market.
I am NOT predicting what will happen… only sharing what I’ve seen. The only way we know we have seen the bottom is 6 months later looking back. But we can learn what bottoms look and feel like.
Maggots under rocks - bears reveal scams
The scams are there the whole time, but remain well hidden by economic growth (excess?)
It’s 1995. A broker recommends I buy Enron as “innovative.” I’m an energy analyst at Farmers’ Insurance investments. Innovative indeed!
I call Enron (pre-internet): “Can you mail me this year’s annual report?”
Enron: “Which one?”
Me: “How many do you have?!?”
Enron: “Five”
Me: “All for the same year?”
Enron: “Yes”
Me: “Send them all!”
In five annual reports, five entities owned 1/5 of each other. I connected the 5 cash flow statements. They didn’t match up.
Untethered to reality, Enron consistently beat estimates. They could make up anything they wanted.
On December 2, 2001, the Enron Corporation filed for Chapter 11 bankruptcy protection, sparking one of the largest corporate scandals in U.S. history, bankrupting their auditor Aurthur Anderson.
These stories abound. One week in late 1999, the CEO and CFO of WorldCom called me at home, to “chat” 5 nights in a row. At the end of the week, I wondered “don’t they have a business to run?” Apparently not.
WorldCom went bankrupt too.
And these were considered the “real” companies vs all the “dot-com boom” companies with no revenues or customers.
In 2000-2001, I discovered a hybrid fraud, Peregrine Systems, a San Diego company, which had a solid 20% growth software business, but literally had FOMO vs their internet comparisons who sold at much higher valuation.
Yes, management teams get FOMO too!
So, they said they had this cool internet software that was truly next gen and growing like a weed. We were a large investor. I recommended they just stick to their knitting as it was 2000, and this stuff was already rolling over. They would have none of it.
So they start reporting this division’s stellar numbers to investors, and the stock goes up.
I do my research, so-called primary research, where I go find customers. No luck. So I ask consultants who recommend software to customers to tell me about the software. Still no luck. I couldn’t find a single customer.
How can you have revenues without customers?
Turns out you can’t. This next gen hot tech division had no revenues, and the CEO and CFO of Peregrine Systems went to jail for drawing well outside the lines.
Other companies overextend themselves the same as individuals with too much debt.
It happened in the housing crisis, with well-respected names slowly and then all of a sudden becoming troubled children like Countrywide (I had a mortgage there at one time, did you?), Bear Stearns (I was a client), Lehman Brothers (I was also a client).
Speaking of buying falling knives, BoA paid $4 billion for Countrywide in January 2008. Five years later BoA had paid about $40 billion in legal costs related to earlier claims made against Countrywide.
Unpopular opinion: Bad actors and excessive risk takers are part of a functioning economy.
They tend to get revealed like bugs under a rock, when the economy slows down and thus they can’t keep hiding their ponzi scheme. That’s why you see more fraud announcements around market bottoms.
Lehman was one month before the 2008 bottom (and that bottom got re-tested in March 2009)
And now?
Risk assets trade together in extremes, and the tip of the tail of the dog of risk assets this cycle is crypto.
Not to get into the weeds too much, but stablecoins were invented to provide a digital equivalent to US Dollars, which was used extensively in DeFi trading and for swapping from one coin to another without going through US Dollars (ie using a bank).
The need for stablecoins in DeFi became painfully obvious to me when I was at CoinCloud trying to figure out how to hedge our DeFi portfolio, and seeing that both the coin you are getting interest in and the one you are staking are moving around by 30%.
It’s like a weekly reliving of the Mexican debt crisis of the 1980s.
Latin American countries had borrowed in dollars but their currencies crashed vs the dollar so they owed back multiples of what they borrowed and couldn’t afford to repay.
Trading DeFi where you are loaning and borrowing in two different “currencies” or coins, that are both going up and down by 30%, sometimes in a day was insane and resulted in being automatically being “stopped out” of your position at the worst possible time. So, if you take the reserve currency, the one you are staking and at least stabilize that, the market becomes easier to navigate.
Thus stablecoins entered DeFi during 2021, and many stablecoins were top 10 crypto marketcap coins due to their broad use in DeFi.
Problem: not all stablecoins are created equal.
Huh?
If they are all supposed to be worth $1, ie stable, why are they different?
Some hold gold or US Dollars as collateral. Some are partially collateralized (the irony is not lost on me here, this is the DEFINITION of Fiat currency, and here we are in crypto which denounces the Fiat dollar system as inflationary in favor of Bitcoin, and these stablecoins are using Fiat systems).
Other stablecoins are algorithmic.
Huh again?
They have a “sister” coin, in this case LUNA and a treasury, and they work using an algorithm to effectively keep the stablecoin pegged at $1. Stating the obvious, algorithms are meant to be hacked. There was a tweet posing how to break TerraUSD below $1 and it went on to posit that if that happened there would be no bottom.
Weeks later that strategy was tried and it worked. $40 billion lost.
There are rumors that the trading desk on the other side is none other than Citadel, the hedge fund in the midst of the Gamestop/Robinhood scandal where Robinhood gets most of their revenue from Citadel, and Citadel had invested in a hedge fund that was losing a fortune betting against GME… Robinhood says they had to stop options trading in certain names because of Robinhood’s own financial situation, but… Citadel definitely benefited
So on TerraUSD/Luna trade, Citadel is rumored to have used the strategy posed on Twitter, and broke the stablecoin's dollar peg and it’s sister coin's treasury was drained trying to defend it. Whereas the coins lost $40B in value, that’s $40B in profits for a short seller.
We may never know what really happened, but these are the kinds of stories and scandals that emerge more in bear markets.
How do we spot a bottom? And, how do we buy there?
By definition, bottoms form when everyone capitulates. There are no more sellers left. The problem is, that capituation includes you and me. We sold.
My best tip which I have had success with, but not all the time, is to study market psychology in good times and bad, and make a spreadsheet of buy prices under different conditions.
I did this so I could codify my thinking around market bottoms and be less emotional. It was still scary to pull the trigger and buy when everyone was saying they’d never buy stocks again (2003), and that the days of double digit market returns were over (sound familiar?).
Specifically, if you want to create a spreadsheet like I describe:
Pick a sector you want to study, say tech
Look at sub-sectors (SaaS, semis, etc)
Look at valuations in good times (normally priced using ratios of price to sales or PE - and put them in buckets of growth - 20% growers price at 1.2X PE, ie 24 forward PE, for instance) - what is the min and max growth multiples, and give extra multiple points, for the market leaders.
Look at valuations in bad times (normally priced at minimum Price to sales of 2X, but sometimes lower depending on debt levels and perceived risk - in 2002 most tech companies were valued at just the cash they had in the bank)
Look at these valuations over 20-30 year periods to get the full range as bear markets don’t happen every year.
Doing this, 90% of the names in my sheet bottomed at less than 1% of my bottom target price in 2008-9. Not a prediction of price, and not a guarantee that you’ll buy even if you create the spreadsheet.
One thing I can predict: we will have strong bull markets again, and we will also have scary bear markets. It’s human nature.