Buying at the bottom–is it too soon?
Buying back into the market after a major correction can be emotionally wrenching for investors. We all know that successful investing is measured by buying low and selling high. As a result, we want to buy at the very bottom of a correction and sell at the very peak of a major bull move. Fortunately, it isn’t necessary to positively identify every low and every high to be a successful investor.
The recent correction has been steep and severe for major averages and for individual equity investment vehicles. Now investors and traders are wondering if the market has bottomed and this is the time to buy or if the correction will continue. A few weeks ago I wrote that I thought the market would bottom in mid-June and then rebound ahead of the Federal Open Market Committee meeting at the end of the month. But I must admit that I have been surprised by the steep slope and the amplitude of this downturn. I anticipated something milder. So is this it, or is there more to come?
Below is a chart of the Nasdaq showing the recent correction that saw the average drop about 13% from its peak. The past couple of days we’ve seen a nice recovery which could mean that the worst is behind us and the bottom is set. But how can we confirm that the Nasdaq won’t pause for a few days and then drop again? In all honesty, we can’t.
On the chart I’ve added some pink circles that show places during recent corrections where one might have mistakenly believed the Nasdaq had bottomed. In each case, that assumption was wrong and the index continued to decline. So what would have been the result if an investor purchased the index during one of those false bottoms? In each case, the real bottom occurred within a few days or weeks and within a few weeks or months the investor would have reaped a nice profit. Buying at a false bottom is certainly less painful than buying at a market top.
One of the oldest investing axioms is to “buy on weakness and sell on strength.” Buy that definition, this would be a good time to buy back into the market. Certainly it is about 13% better time to buy than at the recent peak in mid-April.
For more conservative investors, there are some ways to reduce the risk of buying during a market downturn. The gold line on the chart is a 200-day moving average. An investor who wants confirmation of a change in trend could wait to buy until the index crossed back above the 200-day MA. Notice that the other times on the chart when that occurred, using the 200-day MA as an entry point would still have resulted in good returns.
The middle portion of the chart shows a Moving Average Convergence Divergence (MACD). Another way to avoid jumping in too early is to wait to buy until the black line in the middle switches back to the positive side. That shows that the index’s momentum has shifted upward. The bottom portion of the chart is a Relative Strength Index (RSI). Right now the RSI is below 50. Once it crosses back above the 50 level that is an indication that the Nasdaq has enough strength to advance.
These are just a few of the technical analysis tools that can help an investor decide the right time to enter the market. They can be used individually or collectively. Unfortunately none are foolproof and any trading system an investor creates using such tools will invariably be wrong at times. In that case, you might wonder why we should even bother to use these tools. Perhaps the best answer to that question is to go back to the statement above about buying when the market is weak. Buying during those periods will always feel uncomfortable and sometimes downright frightening. So sometimes the technical tools do nothing more than provide us with the confidence to jump in when our gut is telling us to stay out.
Have a great weekend. Remember to look for our new blog format next week.