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Jim Cramer’s – Real Money

Chapter 8 on “Spotting Bottoms in Stocks” is one of the best sections of Jim Cramer’s Real Money (review). The chapter is filled with the type of insights you would expect to get from someone with 25 years of experience in the market.
The chapter does discuss spotting bottoms in individual stocks, but Jim spends most of his time on indicators he uses to spot market bottoms. These indicators (collected into three categories) have been shared by all four of the last big market bottoms (1987, 1990, 1998, and the “double bottom” in 2002-2003).
Note: All quotes are from Jim Cramer’s Real Money unless otherwise noted. I’ve cited which page the quote comes from so readers with the book can follow along at home.

1. Market Sentiment

The first group is a collection of the following indicators. The theme here is that bearish sentiment implies that money has already been pulled out of the market and is itching to be reinvested.

  • “The pain makes the front page of the New York Times“ (page 212).
    During a downturn, there will tons of market pundits (and bloggers) writing about how terrible things are. Only when the news hits the front page of the major papers will we consider the market officially bottomed-out.
  • The Investors Intelligence survey of money managers.
    You can get these numbers, which surveys fund managers and compares the % of bulls vs. bears, in Investor’s Business Daily every Thursday, or Thursday nights at Market Harmonics. Cramer is watching for a majority of bears and less than 40% bulls. The idea is that people bearish about the market have already pulled their money out and thus can’t pull the market lower. For more of this kind of discussion, check out the blog Trader’s Narrative, which has an interesting analysis of the American Association of Individual Investors (AAII) bearish sentiment numbers.
  • Mutual fund withdrawals.
    Cramer is looking for “consistent, repeated outflows of several of several months” (page 215).
  • The Volatility Index (VIX).
    Is the market in a panic? Cramer is looking for readings above 40 in the VIX.
    VIX at Investopedia.
  • Oscillators.
    There are a lot of oscillators out there. In general, they are used to indicate when a stock (or market) is overbought or oversold. Jim swears by Helene Meisler’s oscillators over at RealMoney.com, but you’re going to have to pay to see them. Phil Town uses the Fast Stochastics. While Bill Cara is a big fan of the Relative Strength Index (RSI).Once again, Investopedia is a great place to start for Getting to Know Oscillators.

2. Capitulation

This next set of indicators is all about finding a “crescendo” in the market, that last big sell off before the bulls move back into the game.

  • “A dramatic imbalance in the amount of new highs to new lows”.
    We’re looking for a large number of new lows and not very many new highs. Cramer looks for “between four hundred and seven hundred new lows and only a handful of new highs” (page 217).
  • Forced margin selling.
    Investors trading on margin (borrowing money from their broker) need a certain amount of money in their accounts to “maintain” their margin. In down-trending markets, these investors are going to lose so much money that their brokers will force them to sell their positions. Cramer depicts a scenario where the brokers try to get some more money out of the traders during the morning before laying down the hammer and forcing a sale of the trader’s positions sometime between 1:30 and 2:30 in the afternoon. For this reason, Cramer watches for a spike in sell offs between 1:30 and 2:30PM. When the spikes stop coming for a few days, the margin sellers are shaken out and the market bottom is near. I found a surprising source in the SEC, while looking into this:http://www.sec.gov/investor/pubs/margin.htm.
  • “A dramatic spike in volume on the exchanges” (page 219).
    Cramer gives an anecdote to explain this one. I won’t re-tell it. So you’ll have to pick up the book (the book!). The lesson: “Let this serve as a reminder to you not to sell into the big volume after a long decline. That’s the time to buy, not sell” (page 220).
  • Flow of underwriting.
    “You don’t commit capital until the most recent underwritings have worked” (page 220). Cramer describes a cycle of IPO and underwriting activity. It goes something like this: IPO stock prices go up for no reason » IPO stocks are pretty level after the offering » IPO stocks are trashed after the offering » (again) IPO stocks are pretty level after the offering. You want to buy into the market when this last situation is prevalent.
  • Order imbalances.
    “Repeated order imbalances sans news are sure signs that the capitulation has reached absurd levels and you have to make your move to buy” (page 222). You’re only going to see this message if you’re on the trading floor, but maybe someone will report/blog about it if they started showing up more often. Order imbalances at Investopedia.

3. Catalyst

Jim’s stance is that all market bottoms are associated with a real world event. This catalyst brings on an “exquisite moment”, where “you have to buy because the opportunity is so great” (page 222). Previous catalysts were surprise rate cuts by the Fed (1998) and the start of the Iraq war (2003). Amazon’s poor earnings probably doesn’t count. Israel waging war on Lebanon/Hezbollah is probably not going to cut it either, but further US involvement could lead to a catalyst. You can’t necessarily predict the catalyst that will surge us into the next bull market, but you can try to be ready for it.
BONUS – How to tell if you’ve missed the bottom: Jim suggests watching the Bank Index (BKX), which has some typical behavior during, or just after, a big market bottom. “If you see a 10 percent move up in the Bank Index you are already well into the upswing, and it might pay to wait for a couple of profit-taking days to transpire before you commit capital” (page 224). Jim doesn’t give a time frame for the jump. Here’s a chart of BKX from Yahoo. There was a 10% jump last October, which did correspond with a large rally. Presumably, we’ll see another jump at or after a market bottom.
We may not be near the market bottom right now, but a lot of people seem to think we’re on the way. Keep these indicators in mind if things don’t turn around. You’ll want to be able to spot the bottom when it comes.

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Being Wrong – Kathyrn Schultz

  • Unlike earlier thinkers who had sought to improve their accuracy by getting rid of error, Laplace realized that you should try to get more error: aggregate enough flawed data, and you get a glimpse of the truth
  • John Ross – 1818 went looking for the Northwest passage, but came back and couldn’t find it because of an optical illusion. However his 2nd in command (William Parry) did not see the same optical illusion and made it known to the investor of the trip. A year later, William went back and also saw the mirage, but decided to sail right through it. The concept is known as an superior mirage – shows things that do exist, but only much closer. The mountain range was about 200miles away instead of the way it looked (25miles away). Essentially his sense of vision deceived him.
    • Failures of perception capture the essential nature of error
    • For the most part, people accept as true anything they see with their own eyes
    • Ex: when you look at the stars long enough it is easy to interpret their movement to mean they we are the center of the galaxy. Sense’s don’t necessarily give the correct information.
    • Philosophers came up a model of the rift between our minds and the world. Sensing is actually two different operations (normally not separable). The first is sensation, in which our nervous system responds to a piece of information from our environment. The seconds is perception, in which we process that information and make it meaningful. Perceptions is the interpretation of sensation.
    • The mechanisms that form our perceptions operate almost entirely below the level of conscious awareness. Our obliviousness to the act of interpretation leaves us insensitive to the possibility of error.
  • Sensing incorrectly is often a side effect of a system that is functioning correctly, in an abnormal perceptual process.
  • Anosognosia, denial of paralysis, patients say that they can move limbs that aren’t there, see things if they are blind. The brain mistakes an idea in the mind for a feature of the real world. => this shows us that there is no form of knowledge that under certain circumstances can fail us
    • The fallibility of knowledge is gravely disappointing for humans because we really, really love to know things.
    • In sum: we love to know things, but ultimately we can’t know for sure that we know them; we are bad at recognizing when we don’t know something, and we are very, very good at making stuff up.
    • The feeling of knowing something is incredible convincing and satisfying, but it is not a good way to gauge the accuracy of our knowledge
    • The way we actually remember is by rebuilding the memory afresh every time. The vividness, ease to recreate, might be a side effect of the building process itself.
      => unfortunately, Plato’s wax tablet is an excellent description of how remembering feels.
    • If we don’t know something, and know we don’t know it we can admit it. However, if we don’t know something, and we are unsure whether we know it, our brains make up stuff to fill in the gaps. This is called confabulation and we are excellent at it.
    • In the end, everything we ‘know’ is actually a belief.
  • We have implicit and explicit beliefs. However, we only recognize implicit beliefs when we are wrong about them in some way.
    • This because these beliefs are models of our world, and only once we fail do we try to create a new model.
    • The reason we do this is because at some point in our evolution it was necessary to formulate models of the world to survive (ie: I can eat these red berries, but not the blue ones. That rustling sound in the bushes is a bunny I can eat or a bear that will kill me)
    • However, this same mechanism which makes us form theories about important things also makes us theorize about everything.
  • Cuz its true constraint – we confuse our models of the world with the world itself
    • Ignorance assumption – other people just don’t have the facts and we do and have interpreted them correctly
    • Idiocy assumption – they have the facts, but don’t have the brains to comprehend them
    • Evil assumption – they are smart enough, but they have turned their back on it (prevalent in politics and religion)
    • This is the grim side of our passion for inventing theories. Like toddlers, we are quick to take our own stories for the infallible truth, and dismiss as wrongheaded or wicked anyone who disagrees. This also makes it difficult to accept our own fallibility because if we assume people who are wrong are ignorant, idiotic, or evil, we prefer not to confront this possibility in ourselves.
  • Evidence – we should not believe things w/o sufficient evidence
    • We always believe things based on paltry evidence. It is the engine that drives human cognition
    • inductive reasoning – We make decisions based on if whatever evidence we do have supports one conclusion better than another.
    • This makes us ‘leap’ to conclusions, sometimes to the wrong conclusions.
    • Inductive bias (Confirmation bias) – we give more weight to evidence that confirms our beliefs than evidence that contradicts them.
    • This also causes us not to look for or accept evidence that contradicts us
  • Society – many of our beliefs are a matter of fate (where are born, our family)
    • Instead of vetting information we simply vet the source, and then trust their information.
    • Asch study – 3 lines are shown on one paper, 1 line on the other. people asked to say which line is the same length (it is pretty obvious). When asked individually error rate is about 1%, however, in a group where many people answer incorrectly, error rate of the subject jumps to 37%! In another study they showed that when the group answers, our brains function differently, so people’s brains changed how they saw the lines based on the judgment of the the group. Also, it only took 3 fake people to elicit this effect. However if in a big group, just 1 person says the correct answer, real subjects start doing so as well.
    • We also tend to disregard beliefs from people we disagree with or who are unfamiliar.
    • Dissent from within a community is especially damning for a community because it only takes 1 person from that group to help others come to the same conclusion since it is harder to disregard them.
  • Certainty – conviction that we cannot be wrong – mental state of being without doubt
    • The feeling of knowing, our sensory perceptions, cuz its true constraint (thinking that our beliefs are grounded in facts), our biases we bring to bear when we assess evidence for and against those beliefs. Our communities and convictions are mutually reinforcing, so can’t question our beliefs without running the risk of support status, and sense of identity that comes with belonging to a society.
    • this type of certainty can be ‘murderous’ but it is also evolutionarily advantageous because you don’t want to have any doubt that you can’t escape from danger,ect…
    • Spinoza – disbelieving is a two step process – initially accepting and only subsequently rejecting it => they set up an experiment where they told ppl fake things and the interrupted them immediately after. Since they didn’t have a chance to mentally evaluate and reject the fake idea, they reported believing it
  • Being Wrong
    • we cling to beliefs until something better comes along. we are rarely ‘between beliefs’.
    • if we are between beliefs for something big, something that our model of the world is built on, it can make you feel completely confused (panic, anguish, rage and we fear we do not have the resources to find our way in the world again). with your belief of this model of the world gone, your understanding of how the world works is also gone. Until you figure out a new one.
    • being wrong about any type of belief makes you feel something. it is usually this feeling that is we try to avoid. being able to admit you’re wrong depends on your ability to tolerate emotions.
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Safe Havens

  • USD / CHF (Swiss Franc) – both are viewed as safe haven currencies
  • Semiconductors (SOX) always tops and bottoms before the market because they go into everything.