Last week the stock market rocketed off its correction lows with a staggering 6% climb. The extremely negative investor sentiment of October turned on a dime, beginning November with hope and cautious optimism. We have already seen two other sharp rallies, both quickly dissipated, during this market correction that began on July 27th. Only time can tell if this rally has legs or is just another head fake.
It’s entirely possible that this current correction hit its lows on October 27th, and after experiencing this sharp reversal, I feel it’s a good time to explain market bottoms and how they typically trick investors into missing out on the subsequent rally. The stock market bottoms out in similar manners whether it’s a pullback (5-10% drop), a correction (10-20%), or a bear market (more than 20%). There are three major ways market bottoms form, with an infinite number of small variations to keep you on your toes.
V-Shaped Bottom
This is when there is a very steep final sell off immediately followed by a similarly steep market rally (possibly what we just witnessed). Many investors miss out on their opportunity to buy on the way down because the drop is so steep and scary that the fear of a continued drop paralyzes investors into inaction. Worse than the paralyzed investors though, are investors that sell at or near the bottom to alleviate the fear they are feeling. Because, as it often happens, the market reverses course and zooms right back up, leaving investors scratching their heads. The move upwards happens so quickly that many investors don’t buy in because they don’t have time to think, and then with hindsight bias they regret not buying in at the bottom and once again paralysis sets in. This explanation makes it seem like it’s too easy to miss out on a great buying opportunity, but the next type of market bottom reinforces why these decisions are difficult.
Key to Success – Accept that you won’t buy in at the exact bottom and plan to buy into the market incrementally and at different price points during a downturn even though it feels scary.
W-Shaped Bottom
This is identical to the V-shaped bottom and the emotional impact, except with a head fake in the middle of two V-shaped bottoms back-to-back. This type of bottom can test the nerves of the most seasoned investor.
Key to Success: Instead of dismay when the second drop occurs, look at it as a second chance to buy into the market. The first bottom showed you where there is likely support in the market, and you can buy in when the second drop gets near the same price.
U-Shaped Bottom
The V-shaped and the W-shaped bottoms test an investor’s mettle with velocity and this one tests an investor with boredom. This type of bottom is characterized with an absence of direction and feels like the market won’t rise for the foreseeable future, lulling an investor in complacency. As the market slowly begins to rise it doesn’t seem like a trend and the assumption is that it will slowly drop back down to the bottom. By the time many investors realize that the market may actually be rising for real, the prices are significantly above the lows. Many investors plan to wait and buy in during a pullback to lower prices and that pullback never occurs. As prices rise higher and higher it becomes more difficult to rationalize buying in and many investors miss out on the buying opportunity.
Key to Success: If the market isn’t moving in price, use time as a guide to buy into a down market. Generally, the stock market moves up 70% of the time, so don’t get lulled into the feeling that you have all the time in the world to buy.
Please note that investing during a market drop is complex and should be done with the assistance of an Investment Advisor and prepared Investment Plan. There are many false bottoms, and there is always the risk that a 20% market drop can turn into a 60%+ drop. Reach out to me anytime if you want to learn more or have questions about how your investments are positioned.
Photograph by: Dawid Malecki on Unsplash
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