Whenever stocks suffer a major decline it is natural for investors to ask whether stocks are at a bottom? Specifically, what signs can you look for to signal a stock market bottom?

In attempting to answer this question, it is first important to review three key facts about stock market bottoms:

• It is impossible for anyone to know when there is an exact stock market bottom.
  The complexity of modern financial markets and the sheer vastness of the financial system, make it impossible to accurately understand or predict overall Market dynamics.
• It is not important to buy at the bottom.
  The goal of investing is to buy low and sell high, not to buy at the lowest price and sell at the highest price. Buying somewhat near the bottom will provide significant profits, as long as you have patience and the financial fortitude to withstand some near-term losses (remember, if you can’t suffer losses, you can’t win in this stock market game – Fear of Losses Leads to the Dark Side).
• Stocks do not bottom when economic or business fundamentals improve. In fact, many times stocks bottom on the worst possible news.
  This quote sums up this last point quite well:
  

  “Market bottoms are less about an improvement in the fundamental situation, whether the economy or outlook for earnings, and a lot more about getting rid of all the anxious investors.” – Bruce McCain, CIS, KeyCorp.

Despite the above points, it is still, of course, vital for investors to buy low, and so we need to establish some guidelines to at least help us navigate stock market corrections.

In my view, what causes a stock market bottom is a slight change in investor sentiment. Stock prices are, in reality, mostly influenced by human emotions, which are entirely transitory, and quite malleable. Nobody can withstand any emotion, let alone fear and despair, for any extended period of time. Eventually, because of some tiny spark of positive news, emotions change and fear turns to relief, and despair to hope.

One of two things always happens around stock market bottoms for the Market, in general, and for individual stocks: Either there is a realization that the economic reality is not as bad as was feared, i.e. there is relief, or there is a belief that the dire economic situation is not getting any worse, i.e. there is hope.

So when searching for a bottom in either the stock market as a whole or in individual stocks, it is important to look for news (or more appropriately interpret the news) that indicates either that economic fears are exaggerated and/or that the fragile economic situation has been stabilized.

In terms of the current market sell off, I think there are two approaches here. As for the US, I do believe the economic risks are exaggerated, and the current crisis seems to actually benefit the US in many ways. As such, I would imagine that in due time, the economic news for the economy, in general, and for companies, in particular, will show that the reality is not as bad as we feared. As for the Euro crisis, I think it is clear that the situation is actually spiraling out of control. So for the Euro, I would look for news or political actions that signal stabilization.

Incidentally, if you invert the above reasoning for finding stock market bottoms, you come to some pretty guidelines for finding stock market tops, both for the Market, in general, and for individual stocks. Basically, stocks top when either there is a realization that the economic reality is not as good as was projected, i.e. expectations are dashed, or there is a belief that the strong economic situation is not going to get any better, i.e. things have peaked. The tricky part about tops is that business fundamentals always look so good at the top, it’s difficult to comprehend why expectations are not met and/or why the situation has peaked. For this reason, it is always important to be wary of good news and to think of selling on positive news.