Editor’s note: This article was originally published in 2020 when the market fell due to the spread of the coronavirus and has been updated for today.
When this was originally written, fears about the possible effects of the coronavirus had gripped the stock market, with the major indexes falling over twenty percent in three weeks. That decline, and every other sustained decline, usually leads to two questions: How do we identify the point at which such declines end, and what do we do when we think we’ve identified that point?
Analysis of markets driven by fear
Let’s face it, trying to logically analyze a massive, rapid drop in the stock market is often futile. Fear is the dominant factor in such a move, and fear has no respect for quaint, old-fashioned notions of fact or reason. However, this does not mean that fear can be dismissed. Until it subsides, it must be respected when trading and investment decisions are made. That then leads to its own important question. How will you know when the fear is over?
The easiest way to identify that time is to listen to the headlines. Like it or not, we are all influenced by the media, and constant repetition gives an impression of omnipresence that reinforces fear. But at some point, even if the situation still deserves coverage, the media will move on, if for no other reason than that consumers are bored and no longer see or read things about what ended up causing the panic.
This does not mean that the problem has disappeared, but it indicates that the fear of it is, and this makes a recovery in the stock market possible.
What does a bottom usually look like on a chart?
The second clue can be found in the market’s intraday patterns.
If you look at the chart above, you will see that the bottom of movements down is usually marked by candles that have a rather long “tail” at the bottom. These indicate when continued selling reversed during a trading session, an important factor in establishing a rally.
Not every such pattern will signal a complete bottom, but when it does, it’s usually marked by that kind of day.
Logical turning points
Finally, and least reliably, there are logical turning points. They may come from technical considerations, such as at previous support levels, or around seemingly significant levels such as ten or twenty percent declines. Or they can come from fundamentals, when the selloff has priced in far more than any potential damage from whatever ended up triggering it.
They can serve as a good starting point, something that can lead you to look for other signs of a bounce, but as I said earlier, logic is not that relevant when it comes to fear.
First, have patience. Don’t jump in as soon as what you see as a signal appears. Wait for confirmation, whether it comes from reduced volatility, a few consistent up days, or a change in fundamentals. Waiting may cost you a few percentage points, but it will reduce the chances of jumping in too early.
When it comes to how to buy in, it’s important to understand that almost no matter what you do, the chances are slim that you won’t start buying all the way, and if you try to do so, you’re more likely to that a wrong call.
From my experience on both sides of the market, identifying the bottom of a big, sudden move is one of the many things that is much easier in the trading room than for individual investors and traders. Desk traders see the order flow and know when the big institutional investors will come back, or at least at what levels and to what extent they are looking to do so. Outside the dealing room, however, you do not have that advantage. You have to take your key from the actions of those who do.
This means that you are not going to hit the absolute bottom unless you happen to do so by luck.
This fact should inform the way you buy. If you identify a level that looks promising, don’t jump in with both feet. Dividing your cash into packages and buying in stages makes far more sense. If you do that and the market goes up, that’s good. You have bought some at the bottom. If it goes down, good. You can buy some even cheaper.
Such an average is a way to control your emotions, and when fear reigns, it is a vital part of any investment strategy.
What to buy
This is something you should consider even before there is any sign of panic abating, and there are two schools of thought. The first is that it is best to buy the hardest hit stocks as they have a greater potential for rejection. The second is that you should buy the most robust, as things that have outperformed in terms of fear will continue to be good investments as things calm down.
Both arguments have validity, so the logical thing to do is both. However, there are exceptions to that, and identifying them is an area where logic still has a place.
In the coronavirus-inspired fall, the hardest hit stocks were, for example, in airlines, cruise ship operators and hotels. It makes sense. These companies will feel a direct and lasting impact, regardless of whether the measures taken lead to a recession or not.
On the other hand, stocks of companies that have solid balance sheets and won’t be directly affected but are dragged down with everything else, such as Amazon (AMZN) and Apple (AAPL) can be a good starting point.
If you have cash to put in, either because you sold on the way down or because you already had cash reserves, the most important thing is not exactly what plan to buy back into the market, but that you have a plan at all.
Assessing the level of fear, identifying some possible signals and thinking about what to buy when you do will all help you make rational decisions. Most important of all, though, is to understand that for all that, your timing won’t be perfect, so you should deposit cash in stages rather than all at once.
Doing all of the above when the market is in a dramatic decline will prevent you from making perfect the enemy of good and will be more likely to look back years later on a collapse as a good opportunity to do some good deals, as given time, they almost always are.