How to Pick the Bottom of a Bear Market

Bottoms take time to form, regardless of the latest theory from your favorite guru or commentator. Bear market bottoms take especially long to form because they carry all the wounds of the previous selloff.

Value investors notch far better gains than growth investors during the early phases of recovery, after a prolonged bear market. The reason is obvious: a strong balance sheet goes a lot further than a pretty story after you've been left holding the bag a few times.

Apply classic market wisdom to understand price mechanics at long-term bottoms. Consider this well-known maxim: the bigger the move, the broader the base. This tells us to pay close attention to proportionality when it comes to a new uptrend. For example, don't expect a market to turn on a dime after it declines for over two years.

Source: TC2000

Swing traders act defensively through bear markets, unless short-term charts signal opportunity. Countertrend rallies offer excellent long trades, but they require fast reflexes. Tighten the holding period and step into as many trades as the temporary bull allows.

Try to anticipate where short-covering will erupt. Get in on the same side as professionals, and use the short-seller's panic to turn a quick profit. When the squeeze dies down, find the most obvious resistance and swing back to the short side quickly. In fact, one of the most dependable short-sale entries is just as a short squeeze ends.

Follow the daily chart for key turning points as a bear market evolves, and act defensively at all times. Wait for a favorable reward/risk ratio and don't get tossed around by swings of investor hope or fear. These cyclical events end through the same mechanics as individual equities. And they last a lot longer than most folks expect.

Source: TC2000

Look for the emotional fire to die down, and for investors to turn away from the markets. Then watch for a broad double-bottom or a wide rounded bottom to signal the end of the bear. Track the growth of accumulation and renewed market interest through long periods of basing. The 50-day and 200-day moving averages will then flip over, so the shorter one sits on top of the longer one. That's where you'll find the start of a new bull cycle.

Picking bear market bottoms offers excellent profits for those with precise market timing. But as with other falling knives, entry requires execution against popular sentiment. Most traders and investors look in the wrong places for secular market turns. They follow the commentators and gurus when they should be paying closer attention to moving averages and trendlines.

Don't be fooled by the nervous chatter of so-called experts. Consider their motives for telling you to buy or sell at any point in time. Remember, they're there to make money for themselves, not for the average investor or trader.

Source: TC2000

Watch the technicals closely, and act only after cross-verification favors the next bull phase. There's no hurry! You can scale in over time, or wait for your next-door neighbor to place his or her money at risk instead of you. Avoid getting caught up in trader mentality when you want to be an investor. Many short-term swings trigger much ado about nothing when markets pull above long-term declines.

Remember, you need a precise methodology for buying or selling near cyclical bottoms. Use your own skills to divine turning points, and turn down the volume on the financial channel. Realize that many professionals will tell you to buy so they can dump their losing positions into your waiting hands. Everyone needs a context to trade or invest. Blind enthusiasm just isn't a good strategy for financial success.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. At the time of publication, Farley had a position in Amazon, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback and invites you to send it to [e-mail]. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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