Some Parameters That Can Help Investors Identify A Bottom

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Includes: DIA, ESV, IWM, KMI, QQQ, SPY, USO
by: Aristofanis Papadatos

Summary

This article provides some guidelines, which can help investors identify a bottom.

When the prevailing headlines are extremely negative and many funds are forced to sell a security due to their own limitations, the security usually plunges to unjustified levels.

A strong indication of a bottom is a bullish intraday reversal on extremely high trading volume.

Identifying a bottom can be extremely rewarding, as the rebound off the bottom is almost always steep. Of course no-one can consistently identify the absolute bottom so the parameters discussed in this article can only help identify a bottom within some degree of error. In addition, the bottom does not have to be a long-term bottom; it may be a short-term or mid-term bottom, which can however lead to exceptional trading profits. As we recently witnessed major bottoms in oil (NYSEARCA:USO), Kinder Morgan (NYSE:KMI) and Ensco (NYSE:ESV), these securities will be used as examples so that the guidelines are better understood. While the stock prices of Kinder Morgan and Ensco are highly correlated to the price of oil, the stocks bottomed on different dates from oil due to their own specific reasons.

1. Extremely negative headlines

All the above securities bottomed when the headlines for their fundamentals were extremely negative. The inventories of oil were at all-time high levels, causing great concerns that even the existent storage capacity might not be sufficient for the new production to be stored in the near future. The end of the embargo of Iran added even more pressure, as 500,000 additional barrels per day would find their way in the oil market.

Kinder Morgan, which has an excessive amount of debt in its balance sheet, seemed unable to borrow from the markets and there were great concerns that it would be forced to issue new shares. As the stock was in a relentless bear market during the last year, the stock price was so low that the secondary offering would cause excessive dilution to the shareholders. Eventually, the company avoided the secondary offering by decimating its dividend by 75%. Nevertheless, that was a great disappointment for most of the shareholders, who were holding the shares mainly for its high dividend.

Finally, Ensco reported excessive losses in Q4 due to massive asset write-offs and announced on the same day the essential elimination of its dividend, which was remarkably high until last year. All in all, the common denominator in all these three bottoms was an atmosphere of extremely scary headlines. More specifically, both Kinder Morgan and Ensco bottomed on the day they decimated their dividends. This is almost always the case; major bottoms are witnessed on the day of a very negative piece of news.

2. High trading volume

The negative headlines, which prevail near the bottom, usually cause a pronounced increase in the trading volume of the stock or commodity. Thus it is useful to compare the prevailing trading volume to its 3-month average in order to detect such a remarkable increase. After an extended downtrend, when a security plunges due to an extremely negative piece of news but manages to close up for the day on extreme trading volume, this is usually a strong signal that the security just bottomed. This is exactly what happened in the case of Kinder Morgan and Ensco, both of which initially plunged on the announcement of their dividend cuts but strongly rallied after the first trading hours and closed sharply up on that day.

3. Forced sell-off

A major bottom is often witnessed when a negative piece of news forces many institutional shareholders to sell a stock regardless of its fundamentals. This indiscriminate selling causes a plunge of the stock to unreasonably undervalued territory until the bargain hunters prevail and set a solid bottom for the stock.

This is exactly what happened in the cases of Kinder Morgan and Ensco. More specifically, when they decimated their dividends, by 75% and 93%, respectively, many institutional shareholders, who were holding the stocks for their high dividends, were forced to sell the stocks as they no longer satisfied the requirements of their portfolios. That indiscriminate sell-off was a major contributor to the initial plunge of the stocks shortly after the announcement of their dividend cuts. As soon as that sell-off was complete, the bargain hunters took over and established a solid bottom for these stocks.

Conclusion

To sum up, a major bottom is in place when the prevailing headlines are extremely negative and many funds are forced to sell the securities due to their own limitations, regardless of the fundamentals of the securities. A strong indication of a bottom is a bullish intraday reversal on pronouncedly high trading volume. Investors who try to identify a bottom in order to greatly profit from the strong ensuing rebound should pay attention to all these factors. Nevertheless, it should be mentioned that the above rules are not written in stone. Even if all the above criteria are met, one can never be sure that a bottom is really in place. The above criteria just favor the odds of a bottom.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.