Don't Just Do Something. Sit There!

Christian Szell: Is it safe?... Is it safe?
Babe: You're talking to me?
Christian Szell: Is it safe?
Babe: Is what safe?
Christian Szell: Is it safe?
Babe: I don't know what you mean. I can't tell you something's safe or not, unless I know specifically what you're talking about.
Christian Szell: Is it safe?
Babe: Tell me what the "it" refers to.
Christian Szell: Is it safe?
Babe: Yes, it's safe, it's very safe, it's so safe you wouldn't believe it.
Christian Szell: Is it safe?
Babe: No. It's not safe, it's... very dangerous, be careful.

Those words from Marathon Man always chilled me. Laurence Olivier kept asking them again and again as his character -- the sadistic dentist Dr. Christian Szell -- painfully tortured Dustin Hoffman's mouth with a dentist's drill in the 1976 movie.

I am reminded of that film every time we get a big selloff. One of the questions we get each correction is whether or not traders/investors should try to pick market bottoms. The background music is an orchestra of bottom callers, the vast majority of who are, shall we say, premature. Eventually someone gets it right, but I never have been convinced it wasn't a function of random luck.

For the vast majority of Wall Street participants, however, this guessing game tends to be rather expensive.

The good news is that it can be done. There are, on occasion, situations where all of the technical and sentiment indicators align "just so." When all the stars and planets line up, it may be worth taking a high-probability stab at that with a little money (a toe in the water so to speak).

The bad news is this is exceedingly difficult. The ideal conditions and circumstances for bottom picking are rare, and the tools necessary to do so are even rarer. Most traders and investors do not have:

• the requisite skill to identify these circumstances;
• the obligatory patience to wait for these conditions;
• or the compulsory discipline to cut losses when the trades don't work out.

Rather than tell you if it is safe here or not, let's consider a different strategy.

Consider the following chart (it's either a market or stock). Each of the red circles is a potential bottom where you could have caught the proverbial falling knife:

Click here for larger image.

Had you bought this at what looked like any of these bottoms, you would have suffered significant losses.

From a risk/reward standpoint, there are much higher-probability trades/investments to make, with lower risk. This balance leads to better overall returns.

Now consider the same company as above, only with the chart extended a little further in time. It reveals two much better entry points than the bottom guesses. The first is when the downtrend was broken, and another entry when the horizontal resistance was overcome.

Click here for larger image.

You would have been much better served buying this stock (or market) when the relentless, multiyear downtrend broke (circle 1) than trying to repeatedly guess the bottom. The next advantageous strategy would be to add to the position -- average up -- after the horizontal resistance is broken (circle 2).

Oh, and the stock I have been using as an example?