Don’t Buy Stocks Without These 5 Signs

08/22/2011 9:30 am EST

Focus: MARKETS

Michael Cintolo

Vice President of Investments and Chief Analyst, Cabot Heritage Corporation

The stock market will tell you when it’s bottomed, and it doesn’t like to be rushed, writes Michael Cintolo, editor of Cabot Top Ten Weekly.

I want to expand upon something I touched on in a special video I did last week during the market’s mini-crash. In that video (click here to watch it), I presented a couple of examples of past market downturns and looked at how they bottomed out.

No two markets play out exactly alike, but history does rhyme to some extent, and here are five things to look for in the weeks to come.

First, it’s highly likely that the recent bounce that persisted through Monday will fail. That doesn’t mean it will lead to another collapse, but the odds of the market running straight up from here are very low. In fact, if it somehow made it most of the way back toward its high right away, it would probably be etching an even larger top.

Second, expect choppy action for many weeks. Following sharp sell-offs like we just saw, bottoms are generally a process, not an event—it takes time to wear out all the shareholders that, to this point, have been too stunned to let go of many of their shares.

So don’t anticipate straight-up or straight-down action. More likely, there will be some big gaps, big reversals, reversals of those reversals, and so on.

Third, somewhere in the vicinity of four to ten weeks after the initial low, look for a re-test of those lows. That would put us in the vicinity of early September through mid-October.

Now, that re-test doesn’t have to find the indexes dropping down precisely to the prior lows—sometimes it’s higher, sometimes it’s lower. And sometimes you see multiple re-tests of the low!

Fourth, during that re-test, you want to see some positive divergences—the number of stocks hitting new 52-week lows should dry up compared to the first low (come in less than 1,292).

And, importantly, you should see many growth stocks (not just defensive-type issues like utilities or food stocks) well above their early-August lows. That tells you that, while the headline Dow or Nasdaq may look sick, the action underneath the market’s hood is more encouraging.

Fifth, you need to see the market and individual stocks take off to the upside. This last part might seem obvious, but you’d be surprised how many investors try to jump the gun!

This is how a bottom occurs—not with one panic day, but over many weeks, as big investors re-position their portfolios away from what’s already been played and toward newer names. Bottoms are a process, not an event.

What happens if one of these steps doesn’t occur? What if the "re-test" turns into a full-fledged rout? Well, then, you wait patiently for a bottom to be put in!

There is no set timetable for a low—yes, the re-tests can occur in the four-to-ten-week time frame mentioned above, but sometimes it takes much longer, especially if it’s a deep bear market. The key is to wait for a bottom to be built, and then for upside confirmation, before taking big swings at growth stocks.

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