How To Tell When The Stock Market Will Stop Falling, And What To Do When That Happens
Editor's Note: This article was originally published in 2020 when the market dropped as coronavirus spread and has been updated for today.
When this was originally written, fear of the possible impacts of the coronavirus had gripped the stock market, with the major indices falling over twenty percent in three weeks. That drop, and every other sustained decline, usually leads to two questions: How do we identify the point where such declines end, and what should we do when we think we have identified that point?
Analyzing Markets Driven by Fear
Let’s face it, attempting a logical analysis of a massive, rapid drop in the stock market is often futile. Fear is the dominant factor in such a move, and fear has no respect for quaint, old-fashioned notions like facts or reason. That doesn’t mean fear can be dismissed, however. Until it subsides, it has to be respected when making trading and investing decisions. That then leads to its own important question. How will you know when the fear has passed?
The easiest way to identify that time is to listen to the headlines. Like it or not, we are all influenced by the media and constant repetition gives an impression of ubiquity that enhances fear. At some point though, even if the situation still merits coverage, the media will move on, if for no other reason than that consumers are bored and no longer watching or reading stuff about whatever caused the panic.
That doesn’t mean that the problem has gone away, but it does indicate that the fear of it has and that makes a recovery in the stock market possible.
What Does A Bottom Usually Look Like on A Chart?
The second clue can be found in the market’s intraday patterns.
If you look at the chart above, you will see that the bottom of moves down is usually marked by candles that have quite a long “tail” on the bottom. Those indicate when continued selling reversed during a trading session, an important factor in setting up a recovery.
Not every such pattern will signal a complete bottom, but when it does come it is usually marked by that kind of day.
Logical Turning Points
Lastly, and least reliably, there are logical turning points. They may come from technical considerations such as at previous support levels, or around seemingly significant levels like ten or twenty percent declines. Or, they may be come from fundamental factors, when the selloff has priced in way more than any potential damage from whatever sparked it.
They can serve as a good starting point, something that can prompt you to look for other signs of a bounce, but, as I said earlier, logic is not that relevant in the face of fear.
First, have patience. Don’t jump in as soon as what you see as a signal appears. Wait for confirmation, whether that comes from reduced volatility, a few consistent up days, or a change in the fundamental situation. Waiting may cost you a few percentage points, but it will reduce the chances of jumping in too soon.
When it comes to how to buy in, it is important to understand that almost no matter what you do, the chances are that you won’t start buying right at the bottom, and if you attempt to do that you are more likely to make a wrong call.
From my experience on both sides of the market, identifying the bottom of a big, sudden move is one of the many things that are a lot easier in the dealing room than for individual investors and traders. Desk traders see the order flow and know when the big, institutional investors are coming back in, or at least at what levels and to what degree they are looking to do so. Outside the dealing room, however, you don’t have that advantage. You have to take your key from the actions of those who do.
That means that you aren’t going to hit the absolute bottom unless you happen to do so by luck.
That fact should inform the way you buy. If you identify a level that looks promising, don’t jump in with both feet. Splitting your cash into parcels and buying in stages makes far more sense. If you do that and the market goes up, good. You have bought some at the bottom. If it goes down, good. You can buy some even cheaper.
Averaging in like that is a way of controlling your emotions, and when fear reigns, that is a vital part of any investing strategy.
What to Buy
This is something you should consider even before there are any signs of panic subsiding, and there are two schools of thought. The first is that it is best to buy the hardest-hit stocks as they have more potential bounce. The second is that you should buy the most resilient, as things that have outperformed in the face of fear will continue to be good investments as things calm down.
Both arguments have validity, so the logical thing to do is both. There are exceptions to that though and identifying them is one area where logic still has a place.
In the coronavirus-inspired drop, for example, the hardest hit stocks were in airlines, cruise ship operators and hotels. That makes sense. Those companies will feel a direct and lasting impact, whether the precautions taken lead to a recession or not.
On the other hand, stock in companies that have solid balance sheets and will not be directly impacted but are being dragged down with everything else, such as Amazon (AMZN) and Apple (AAPL) may be a good starting point.
If you have cash to deploy, either because you sold on the way down or because you already had cash reserves, the most important thing is not precisely what plan you have to buy back into the market, but that you have a plan at all.
Assessing the level of fear, identifying some possible signals, and thinking about what to buy when you do will all help you to make rational decisions. The most important thing of all, though, is to understand that for all that, your timing will not be perfect so you should deploy cash in stages rather than all at once.
If you do all of the above when the market is in a dramatic decline you will stop yourself from making perfect the enemy of good and will be more likely to look back years later on a collapse as a good opportunity to pick up some bargains which, given time, they almost always are.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.