Written by: Benjamin Bimson CIMA®, CMT® / CIO, Trek Financial
The reality of market declines is unpleasant, but taking control by staying focused and remaining calm is truly important. By looking at the realities of bear markets, we can look for signs that may point to more normal times. There is an anatomy of market declines that can be helpful when headlines and market returns seem relentlessly bad.
Stock market corrections tend to go through a process when they form a bottom. The steps are as follows: oversold markets, market rally, retest, and finally breadth thrusts. It is notable to admit that the process varies in length and some processes skip steps. In 2018 and 2020 we had two market downturns that did not ever retest and would qualify as a V-shaped recovery, with one that simply went down and immediately went into recovery mode. It is also important to note that no two corrections are identical and there are always unique elements and reasons that markets decline. Nevertheless, it is helpful to see where we are versus what we can be looking for or may still need to work through.
Oversold Markets
The first step in a bottoming process is to get to an oversold condition. In the chart below you can see that oversold conditions have been reached beginning in late April 2022 and have recently risen a bit with the latest rally attempts. Therefore, we can say that oversold conditions have been met in this market selloff.
Chart Source: Ned David Research
The Rally
The next step for the bottoming process is to see a market rally. While markets have risen from the lows, and that is a welcome thing, the market rally accompanying oversold conditions that would check the second step off the list would be a meaningful rise in the market from the low with broad market participation. This is not simply a few percentage points but tends to be very noticeable. However, we have not yet seen this type of rally yet, despite an encouraging rally earlier this year that quickly faded. Until we get a meaningful rally, investors should be prepared to continue to look for the bottoming process to continue.
Here is a table from Ned Davis Research that shows that most notable declines have had a retest that can even be lower than previous lows observed in the indexes. Notable facts are the mean number of days for retests at 95 from rally highs to new lows and the number of days a retest tends to end.
Chart Source: Ned Davis Research
The Retest and Breadth Thrusts
Finally, the last step in a market bottoming process is a rally following a retest that is accompanied by several signs that the rally is broad and sustainable. This is where the real growth in investments can happen! Those are called Breadth Thrusts. This is a healthy sign for the markets that the worst is likely behind the market and a new bull market has begun. Furthermore, the retest can be skipped if there are widespread breadth thrusts. Until the breadth thrusts happen, investors should interpret the market as continuing to search for a market bottom.
It is helpful to remind ourselves that there is not a strict timeline to a bottoming process and that it is a process and not usually an overnight thing. By looking at the facts and remaining objective, investors can help themselves avoid the inevitable emotional rollercoaster that market declines can bring.
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