Market Pull Back or Market Crash?

"We're gonna need a bailout..."

I received the following question in the comment section of my last post:

Can we have a post describing a "Pull Back"? How to spot the difference between a pull back and a significant crash. If I am eying a stock and waiting for a pull back, I want to be able to know when I can buy. But I don't want to buy during what I believe to be a pull back and have the stock continue to drop for a week while I lose money.

That is a good question.  The overall market has pull backs all the time.  Crashes happen more rarely.  Pull backs can happen due to a number of factors including bad financial news, a major global news event, profit taking and many more.  Recent pull backs have happened due to the revolutions in Libya and Egypt, the earthquake in Japan, Greek debt issues, poor European bond sales, etc..  Crashes happen when there is a major fundamental problem that comes into the light.  In 1929 the US stock market crashed due to a bubble created by security purchases made on margin, (credit).  Wild greedy buying lead to over priced stocks and then the bottom fell out and a panic ensued.  This happened again in 2000 when investors bid up the prices of the ".com" stocks to over valued levels;  selling to escape over valued situations and a realization that companies like Pets.com did not have any intrinsic value or real profit potential lead to another crash.  In 2008 risky mortgage derivatives fueled by ignorant home loan applicants, evil/greedy investment/retail bankers, and over optimistic and unrealistic U.S. government home ownership policies lead to another crash.

All that historical junk about crashes and pull backs is sort of interesting and can serve as examples of what a crash or a pull back has looked like in the past.  Judging just by the aforementioned examples we can see that crashes happen when there is something intrinsically wrong with the financial markets, pull backs happen more often then not when investors get nervous or the buying demand recedes temporarily and more sellers come into the market to take profits.  A decent analogy would be that your life is in a pull back if you get drunk and fall out of a strange bed when you see who you woke up next to the next morning.  That is a definite pull back and very unfortunate but it isn't a massive issue.  Your life is in crash mode if you get cancer, or get a divorce.  Those types of things are REALLY going to change the way that things are in your life forever and it will be a very long time until things normalize again.  So when your trying to decide if there is a pull back or a crash ask yourself if what is happening is going to change fiscal law and/or policy at some point, or if it is a more temporary global set back like an interruption to global oil supply, or bad national unemployment numbers.

Most importantly, how can we tell when a pull back or crash has petered out and it is time to buy.  Unfortunately, no one can call a bottom in the markets.  This gives us a couple of options.  We can find stocks we like, figure out what a good price is to buy them and then buy the stock in increments as it gets cheaper and cheaper.  If that seems risky we can wait until the market starts to recover significantly and then do our buying.  Although we can't perfectly call bottoms in stocks or the markets there are some strong signs that appear when the markets are done pulling back or crashing.  When there is bad financial news related to the crash or pullback and the market doesn't react by going down anymore it can be a sign that the pullback or crash is over.  There are also technical and fundamental resistance levels that can act as a  price floor for a pullback or crash.  Watch a financial cable channel during a down turn in the market and you will definitely see analysts talk about these levels.  They will be on CNBC or Bloomberg talking about the specific resistance levels for the major indexes.  If you take note of a couple resistance levels and the market does not break down through them for a week or two it may be a sign that it is time to buy, (there are resistance levels for the different financial averages;  Dow Jones, NASDAQ, etc.).

The best advice I can give is to find quality stocks you like, know the price and valuation that you like them at then be patient and wait for an oppurtunity to buy.  Example:  Someone may have bought Ford in March 2008 at around $5 a share because Ford had restructured and the logic at the time was to buy Ford because its tangible assets alone where worth $5 a share.  The market had run down very far at that point in time.  However, in November 2008 Ford's shares plummeted to $1.43.  Missing that bottom in Ford's stock price was certainly unfortunate, but it was not a massive mistake because Ford's stock was undervalued at $5.  By November 2009 Ford's stock price was $9 an 80% gain, and by November 2010 Ford was at around $16 a share a 220% gain in just two years.  The moral of the story is that it is more important to know the value of a stock then call the bottom of a pull back or market crash.