Getting Ready for the Bottom

What to buy and how to know when it’s time to buy them

What changes as a bottom approaches

As the bottom approaches, poor performance in financials becomes more benign. While it still may lose value, it moves from a market laggard to a market leader to give us a sign that things are beginning to change. Indeed, from July to August 2008, the banking sector has done fantastically well – and this includes the turbulent declines seen in early October – with many stocks gaining 20% in three-months time. That is awesome performance in a bear market and gives us reason to think that the worst is behind us already. (Ed. note - well you cannot win them all but "reason" is not a trading signal)

And at the bottom

If the model holds true then at the bottom we should also see life in technology stocks. The usual suspects, such as semiconductors, should begin to firm and even though the stock market may still experience another bout of selling the tech sector should not be follow suit, at least not to the same degree.

What to buy

By now, the reader should have surmised what the proper areas in which to mine opportunities will be. Financial and technology sectors should be the areas leading the market out of the gate and while more cyclical sectors such as industrial and consumer cyclicals are likely to participate in the new bull market it should be financial and technology that lead the pack.

It is difficult to assess what individual stocks or even industry groups will be the ultimate leaders in advance as so much of that analysis depends on these areas actually starting to outperform. Since we cannot know that in advance, we must use a broad-brush approach and start nibbling on sector proxies. The bank and technology sector ETFs would be good vehicles to use to start. From there, we can focus on industry groups as we drill down to specific leaders.

To get an idea of how the start of the recovery might look, we can examine how the last bear market transitioned to a bull market. Since the bear of 2000-2002 was technology driven while the current bear has been financials driven, we can look at how the technology ETF recovered in 2002 –2003 in order to get an idea of how the financial ETF might perform in the coming months.

In September 2002, just a few weeks before the Nasdaq bottomed, the tech ETF began to outperform the market. But as we know it was not straight up from there and the ETF, and the market, chopped around for months.

But in June 2003, when the ETF was able to climb above its initial upside reaction off the October market bottom, we got a confirmed signal that a bull market was underway.

I would expect the current market to show similar performance when the financials and banks in particular are able to break free from whatever trading range is forming now, keeping in mind that it will likely take months to develop to repair the carnage we’ve seen in this sector.

Note posted in November - As of this  update, the banking sector was giving the support line seen above (the lower horizontal) a serious test. If it can hold then the path drawn on this chart - updated only through October - is still valid. The length of time it will take, however, can be months longer than implied. Alternatively, another rally and test is possible. But none of that is the point of this article. What is the point is the bear market, transition period and then eventual bull market.

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