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3 Ways to Tell if a Stock Has Hit Bottom

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As famed value investor Benjamin Graham once mused, it’s better to buy an investment after a decline than after it has risen. One of the goals when buying low is to avoid catching a falling knife. To the extent possible, if you are about to buy a stock after it has had a substantial decline, you should abort the mission if you believe there are factors present which could cause it to fall even more.

This raises the question: How do you know if a security’s price is close to its bottom? Prudent analysis will help. But even with the most sophisticated tools available today, there’s no guarantee that you’ll get in at just the right moment. That said, when scanning the wonderful world of investments, you might consider dividing your due diligence into three categories. This includes fundamental analysis, technical analysis, and a third that I’ll call ‘other’ that includes looking at recent news of a company, the level of (legal) insider trading and so forth.

In this post, we’ll briefly touch on each with the hope that you will find something to help you in your business. 

Fundamental Analysis

Fundamental analysis consists of a company’s finances, quality of management and business ratios which can provide insight in to the health of a business. Is the company profitable? Is its earnings consistent and have there been any positive or negative surprises? Does the company have a lot of debt relative to others in their industry? The list is extensive and some of the information is more predictive. Is the current price above or below its fair market value? Determining intrinsic value is a common technique which may help. Some investors prefer stocks with a low valuation ratios (P/E, P/S, P/B, etc.). However, this will vary by industry and even when there is a low P/E, it’s not unusual for it to remain low for quite a while before the stock’s price rises. In my opinion, fundamental analysis is essential, but it only provides a partial picture. 

Technical Analysis

More on this topic

Many advisors love the charts. Although I use technical indicators on a regular basis and believe they provide insight, I believe that like fundamental analysis, when used in isolation they only provide part of the story. More specifically, I use RSI, the Relative Strength Index. A reading below 30 indicates an oversold position while readings above 70 indicate an overbought security. However, a stock can remain above 70 or below 30 for a while before a price reversal. I also use the Directional Movement Index, or DMI. DMI includes three indicators (DI+; DI-; and ADX) and helps determine if a trend exists. If so, it also indicates the strength of the trend. A positive trend is present if DI+ is above DI-, and ADX is above 20 (some use 25 or 30). The higher the ADX, the stronger the trend.

MACD, Chaikin Oscillator, and Money Flow Index are a few additional technical indicators. Caution: When using technical indicators, you should use two or more for confirmation. 

The ‘Other’ Analysis

This is the catch-all category. Is there any recent news on the company and if so, is it positive or negative? Has the company’s CEO, CFO, CIO, etc., been accumulating shares or selling? Is the business environment favorable for companies in the industry? Are there any pending regulations or legal challenges that may have an impact on the company? Is the economy strong and is there demand for what the company offers? Company profits are possibly the most important ‘other’ item of all.

Picking individual stocks or even packaged products such as mutual funds or ETFs requires that you do your homework. If you don’t, it could cost you. As a final word of caution, I would not rely on the opinion of just one individual, even if they are considered to be an expert. Why? Not to pick on him, but in early 2000 Jim Cramer was quoted as saying that tech stocks are the only place to invest (paraphrased). As smart as Cramer is, this is a lesson that even the best get it wrong sometimes. 

Until next time, thanks for reading and have a great week!