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How can an investor know whether the markets have bottomed out

Apr 11, 2022 / Dwaipayan Bose | 27 Downloaded | 1593 Viewed | |
How can an investor know whether the markets have bottomed out
Picture courtesy - Freepik

Three types of investor behaviours can be observed in volatile market. Some investors panic and redeem their investments when market crashes; this is usually harmful for the long term interests of the investor. On the other extreme, there are some investors who prefer to invest when the market corrects; these investors can get superior returns if they get their timing right. A large number of investors however, prefer to sit on cash and wait for markets to bottom out.

Are you one of these investors? How will you know whether the market has bottomed out? We will discuss some indicators in this blog post.

Demand and supply in stock markets

Before we discuss some indicators of market bottoming, let us understand how the stock market works in the short term. Share price movements in the short term are based on old classical economics theory of demand and supply. Demand of stocks comes from buyers and supply of stocks comes from sellers. If supply of stocks is higher than demand, then the price will go down and vice versa. In other words, when the number of sellers is more than number of buyers, the price will go down and vice versa.

How will you know the number of buyers and sellers in the market? If you have access to a share trading terminal, you can see bid and ask (offer) quotes, in terms of price and volumes. The bid quotes comes from the buyers and ask or offer quotes come from the sellers. Since you can see volumes for both bid and ask quotes, you can get a sense whether there are more buyers than sellers in the market or the other way round.

In this blog post, we are assuming that most of our readers are retail mutual fund investors who do not actively trade in shares, may not have access to trading terminals or may not know how to use them. We will discuss some indicators for market bottoming which average retail investors can use.

You may like to read what should mf investors do when the market is at its record high?

Market trend from price volume data

Below are some simple indicators of market trend and strength of a trend:-

  • If prices are going up and volumes are also going up, it indicates a bullish trend.

  • If prices are going up but volumes are going down, it indicates that investors are cautious i.e. weak bullish trend.

  • If prices are going down and volumes are going up, it indicates a bearish trend.

  • If prices are going down and volumes are also going down, it indicates that investors are nervous of the direction of the market i.e. weak bearish trend.

In a bear market or deep corrections you will see prices falling with high volumes. As the market approaches the bottom, the price will keep falling but with lower volumes. Then when the trend reverses, you will see that, prices are going up and volumes also going up.

Observe trends over time

Remember markets are never unidirectional. You may have pull-back rally in a bear market, when traders cover their short positions. A short covering rally does not indicate that market has bottomed out. Similarly, in bull markets you may see profit booking from time to time, when prices may go down but it does not indicate that the market has peaked. You will have to observe this trend over several weeks or even a few months, to confirm whether the trend is sustaining or reversing, and also, if the reversal from market bottom (if observed) is sustaining.

You may also like to read: what should long term investors do when there is a war

Look at trends of heavyweight stocks

The indicators for market trend discussed in the earlier section are for stocks – you can get price and volume charts of stocks on a number of online portals for financial or market news. You can also get the charts on the portals of the stock exchanges. But how will you know the trend of the market? The main market indices in India are the Nifty 50 and BSE Sensex. Look at the price and volume charts of the heavyweight stocks in the index i.e. stocks with the highest weights in the index. Look at the trend of the Top 5 or 10 stocks of the index and you can get a fairly good idea of market trend. We will now discuss some other indicators of market bottoming and trend reversal.

Price Patterns – higher tops and higher bottoms

Prices move up or down in the stock market on a daily basis. Observe the pattern of Nifty or Sensex in the charts; you can get Nifty and Sensex charts on a number of online financial / market news portals and portals of the stock exchanges. If the index keeps making lower tops and lower bottoms, it indicates weakness in the market i.e. bearish trend. Higher tops and higher bottoms indicate strength i.e. bullish trend. After the market has bottomed, you should expect to see to higher tops and higher bottoms. This can provide further confirmation whether market has bottomed out.

Put Call Ratiotrend

This indicator is only meant for investors who have an understanding of stock or index options. Put call ratio (PCR) in simplest terms is calculated by dividing the number of put options (open interest) by the number of call options (open interest). If PCR is too high, it can indicate trend reversal from bearish trend to bullish trend and vice versa. If PCR is declining from its high on sustained (over several weeks) basis, then it may indicate that market has bottomed out. PCR should be used along with other indicators discussed earlier in this post. Investors who are not familiar with PCR should not despair; the other two indicators can give you a fairly good idea of trend reversal.

How should investors use these indicators?

  • Though fairly obvious, we should mention that you need to see signs of trend reversal i.e. market going up to indicate that market has bottomed out. If market keeps falling then it is has not yet bottomed out.

  • It should also be obvious that you may not be able to invest at the market bottom; very few investors including market experts are able to time the market. If you have indication that market has bottomed, then your risk is lower.

  • As mentioned before, you should observe the trends for at least a few weeks to get a confirmation if the market has bottomed.

  • However, if you wait for a very long period of time to feel confident that the trend has reversed (market has bottomed), then you may miss out on attractive investment opportunities.

  • Historical data shows that, market bounces very strongly from its bottoms. Therefore, you should be able to identify that market has bottomed fairly early so that you are able to take advantage of the investment opportunity; consult with your financial advisor if you are not sure.

  • If you have some indication of market bottoming, but do not feel confident about investing in lump sum due to market volatility, you can invest in equity funds through the Systematic Transfer Plan (STP) from a low volatility fund e.g. overnight funds, liquid funds, ultra-short duration funds etc.

  • As mentioned multiple times in our blog you should always have long investment horizons for equity investments and be prepared for volatility. You should always consult with your financial advisor before investing.

Disclaimer: This article is purely for investor education purposes. It should not be construed as investment advice in the current market conditions. You should invest according to your risk appetite and investment needs. Consult with your financial advisor before investing.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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The information being provided under this section 'Investor Education' is for the sole purpose of creating awareness about Mutual Funds and for their understanding, in general. The views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. Before making any investments, the readers are advised to seek independent professional advice, verify the contents in order to arrive at an informed investment decision.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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