Throughout the first eight months of 2012, investors could not be dissuaded from buying stocks. Bad news was met with a shrug, while good news were heartily embraced. These days, the half-full glass is now perceived as half-empty. Case in point: A solid employment report from the Department of Labor on Friday, Nov. 2, capped off a solid week of economic data, but investors used the seemingly good news of 171,000 new jobs in October — a nice 21.3% month-to-month increase — as an excuse to sell.
And that's important information. You should always tread cautiously when investors appear to be in a cynical mood. Sure, the markets are now a bit more appealing after a modest pullback from recent highs, but there are still ample headwinds in place that could lead stocks to grind lower into year's end. I discussed these headwinds about a month ago.
Yet even as you take a cautious stance, you have to watch for the key signs of a market bottom. When you spot one or several of these indicators, then it will be time to pivot back into a buying mode.
Here are five key indicators I'm tracking…
1. The Fiscal Cliff discussions
Soon after the election is over, you'll start to hear about potential legislative compromises to avert the dreaded "Fiscal Cliff." Make no mistake, a compromise will be reached, either in coming weeks or soon after the inauguration in late January. But it's the outlines of what such an agreement will look like that you need to monitor, not the actual agreement itself.
Once investors get a sense of what kind of economic drag the new plan will have, they will grow more comfortable about economic prospects for 2013. The 3% to 4% gross domestic product (GDP) decrease that the Fiscal Cliff would result is intolerable. But an agreement that affects the GDP by 1% or 2% can be absorbed by an economy that has recently shown fresh resilience.
Value investors are never pleased to see a market drift lower slowly, as has been the case during the past four-six weeks. Instead, they want to see investors throw in the towel in a big way. A look at early 2009 is instructive. The S&P 500 fell 8.5% in January of that year and weakened further as February got underway. Yet it's what was happening in the final 30 days of that market rout that is noteworthy: On Feb. 10, 2009, the S&P 500 dropped nearly 5% in once session and then delivered additional drops of 2% to 3% in coming sessions, culminating in a 4% drop on March 5. A few days later, the bottom appeared to have held and the stunning market rebound began on March 9, 2009.
In recent weeks, the market has shown very little dramatic action, with only a few days of even a 1% drop. For many, we haven't had the full blown selloff we need to see before the next leg of the bull market can kick in.
3. Watch the retail investors' surveys
On several occasions in the past, I've noted that markets tend to bottom right at the moment when individual investors grow alarmed. So keep tracking the weekly sentiment survey the American Association of Individual Investors (AAII) releases every Thursday.
Investors have actually just grown more bullish with 35.7% of them now expecting market upside. You want to see this bullish figure drop below 25% for markets to truly be washed out.
4. A lower bar for 2013
Companies have spent much of the current earnings season lamenting how the challenges in Europe, along with our own Fiscal Cliff concerns, are affecting discretionary spending choices. But you won't necessarily find this downbeat view among Wall Street analysts. Heading into any subsequent quarter, analysts tend to start their forecasts at a fairly optimistic level and then invariably lower those forecasts as the quarter progresses (right up to the end when companies can magically manage to "top estimates").
This process is likely to play out for the fourth-quarter and next year's forecasts as well. Analysts are only slowly adjusting their forecasts to the more sober tone seen on recent quarterly conference calls (and you never want to get in front of a stock that is subject to ongoing downward revisions). You'll want to see this process play out, perhaps during the next two months, so the market can then be set up to overcome an easier hurdle in terms of 2013 (and 2014) forecasts.
5. Track the value metrics
With the major indexes still within striking distance of multi-year highs, it should come as no surprise that the market is no longer inexpensive (as was surely the case in 2009 and 2010). The S&P 500 trades for around 16 times trailing 12 months earnings, which is roughly 1% to 2% above the historical norm. This means we'd need to see stocks fall by 10% or even 15% before they move below typical historical valuations. My personal rule of thumb: Focus only on stocks that already sport trailing earnings multiples that are well below the market average. They could represent ports in a storm if the seas get choppy.
Risks to Consider: As an upside risk, investors may soon take note of the fact that recent economic reports have actually been better than feared and the economic forecast for 2013 may not be as grim as I and others have feared.
Action to Take –> This is a great time to brush up on the stocks you want to own when the economy truly strengthens. You can spend this time determining the "no-brainer" price for these stocks and pounce whether they fall to that level. In addition, this is a great time to lock in profits on any big gainers in order to raise fresh cash for the eventual buying opportunity that will emerge.
– David Sterman
This article originally appeared on StreetAuthority
Author: David Sterman
Look for These 5 Signs of a Market Bottom Before You Start Buying Again