Potential market top approaching?

Today, I’d like to discuss the investment cycle, and where we may be within that cycle. My perspective as a Technical Analyst involves applying sentiment studies and investor psychology to market movements (this also called behavioral finance). In my way of thinking, a properly structured Investment Cycle should  incorporate investor emotion in conjunction with technical trend analysis and economic factors.

This brings me to an update on my new book.

Some of you might be aware of the fact that I am writing a new book on contrarian investing. I’m down to the home stretch – with only a few hours of self-editing left. Then it goes to the “real” editor who will tear me apart and point out what an amateur writer I truly am (its always a lesson in humility). If you have ever written a book, or know anyone who has done so – you will relate when I tell you that its a FAR bigger task than most imagine. Especially when writing a technical book. Writing a blog is comparatively easy. I just spit out whatever has been on my mind or whatever general trading direction I am focusing on that week- and presto! Instant blog.

A technical book has to flow and connect a myriad of concepts to educate the reader in an easy to follow format. My books always conclude with a final chapter called “Putting it all together” (see SmartBounce and Sideways). In that final chapter, I take everything I’ve covered – which in the current books case is vastly more information than I covered in the first two books – and help the reader incorporate it all into a manageable trading plan. My goal for any of my books has always been to help retail investors understand analytical processes in an easy to understand format. The good news is that I’m in the home stretch. For anyone who read Sideways and felt it needed to go deeper down the rabbit hole of analytics- this book is for you!!!

In the opening chapter of the book, I discuss the Investment Cycle. I present two variations of understanding the cycle. One is from the investor emotion perspective – which you may have seen before. Its the classic fear and greed cycle. Here is an excerbt from that introduction (unedited!) with a chart of that behavioral cycle:

The investment Cycle

The diagram below is one that you may have seen before. It represents the investment cycle, as driven by investor crowd behavior. The cycle moves between bull markets and bear markets as investors rotate between the various stages of euphoria and despair. (Note for todays blog: On this diagram is noted a potential position as to where we may be in that cycle right now – along with some potential timing of the next phase in the cycle.)

While examining the investor behavior cycle chart above, you may wonder how an investor can quantifiably identify euphoric market conditions that lead into market peaks. Conversely, you many wonder how we might identify declining markets near the capitation stage of a market bottom. Is there a way to identify which part of the behavioral cycle the market is currently in, and profit by these peaks of emotional buying and selling behavior? Jason Geopfert of Sentimentrader.com (you will be introduced to his work later in this book) suggests that market tops and market bottoms are often identified by a number of reoccurring traits. I’d recommend you keep the following lists handy as a “check list” to regularly ascertain market conditions. The more of the following conditions present, the more likely we are at or near a market top:

 

Goepfert suggests that market bottoms also coincide with reoccurring traits. As with market topping conditions, the more conditions for the list below that present themselves, the more likely we are at or near a market bottom:

• Extreme pessimism

• Oversold breadth (few stocks moving up vs. moving down)

• Risky stocks crash

• Negative media coverage

• Credit slams shut

 

Comments based on that book excerpt

The reason I wanted to copy the above excerpt from my soon-to-be published book was to stimulate some thinking as to where we may be in the cycle. Optimism for stock markets has been very high over the past few years. This excitement built its way into a potential crescendo that might represent those final phases of a topping market. See the top chart.

If we look at Goepfert’s  list in the box above, we might draw some parallels of those conditions to current markets. Are you seeing high optimism in the markets now? Can it be argued that our current access to credit is easy- perhaps too easy? Have you noticed that secondary market offerings are rising? Would you argue that the outperformance by fairly start-up stock sectors like solar and stay-inside technologies is a sign of market speculation? Would you agree that the SPX PE ratio of 40 (trailing), which is the third highest in history, is high? Would you agree that massive valuations on market leading big name tech’s like FAANGs is high?

The problem with viewing the above the cycle is that these factors are all fairly forward – looking. We need to quantify the timing of such a top (if we are near one) by using more quantitative measurements. That’s where sentiment indicators – which I discuss in the book – come in. I use a few of the more reliable sentiment studies in my Bear-o-meter.

Today’s blog, despite the undertone of warnings, wasn’t written to have you sell your portfolio and run for the hills. Markets can remain wrong longer than you can remain solvent, as Keynes once said.

Next week, I’ll present my Bear-o-meter findings for a more timely look at current market sentiment. This might give us further insight as to where we are in the diagram presented at the top of this blog. And if we should be taking action. Stay tuned!

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10 Comments

  • Hi Keith, are you talking about the potential end of the 10+ year bull market here, or only a “significant correction” within an ongoing bull market? Thank-you in advance for your insights. Rick

    Reply
    • Hard to say its the end of a mega cycle Richard–I will go with the “20% correction” type of pullback–but technical analysis allows us to re-evaluate constantly–if we see lower lows and breaks of the 40 week SMA we can start to assume more than a standard correction. Time will tell. The setup is there for anything–but we have low rates and stimulus cheque that counter the items on Jason Goepfert’s checklist….interesting times!

      Reply
  • Can’t wait for the new book! First two Definitely left me wanting more iNformation. Congrats by the way… I hope only the best for you and the eventual release and that you stay healthy and do these blogs for a long time coming… As a young person, I really do enjoy them more than anything else I read out there…

    Reply
  • Where do you get all the energy…maintain a family life and an active cycling schedule? And look after your business and do all your writing? Do you ever sleep?

    Seems to me that watching bonds could be indicative of market tops. I don’t invest in bonds but the recent spike in yields foretells an increase in interest rates generally which will, at the very least, stall equities prices. Never question the intelligence of the bond market.

    Reply
    • Quote by Kurt Cobain: “It’s better to burn out than to fade away.”

      And yes Fred–bond market is smarter than stock market participants. A warning sign for technology and growth stocks, but good for financials, commodities and low-debt companies (staples)

      Reply
  • Hi Keith,

    Thanks for all you do! Just for clarity, is the potential correction you are referring to only related to the Nasdaq, SPY, or all of the indices? I’ve seen the investment cycle chart many times and used to think that it refers to the entire stock market in general as a whole, but lately in this environment with fast algos it seems like each sector currently is in different phases on their own cycle (tech being at re-test phase, financials being at max optimism phase etc).

    I agree with the fundamental reasoning that as yields continue to rise, the discount rates on future cash flows go up and NPV goes down, causing growth stocks with negative earnings to drop. Agree that a rising rate environment benefits banks and insurance companies with increasing spreads.

    On a technical basis though, when I take a look at the charts on the QQQ, it has an inverse head & shoulders pattern on the daily chart indicating a bullish pattern (along with tech performing well the past few days). On the contrary, SPY and DIA has broken to new all time highs today and the reopening trade looking extended, with the XLF on the weekly chart past 70 on the RSI. It feels as though the best news has been already priced into banks, as general consensus incl CNBC continually emphasizes buying the reopening trade, which is a little worrying from potential FOMO and being stuck “bag holding” on a potential pullback.

    Reply
    • Hi Matt
      I agree that you will see less broad selloff. In fact, I have harped on the most vulnerable sectors being those that were the strength last year–tech, discretionary, clean-green enviro stuff, and stay-inside stocks – so indices most exposed to those sectors are most vulnerable. Seems that even the indices that are not super-exposed still hold some of that content, perhaps too much. SPX is about 30% in those sectors, even the INDU holds its share So they will decline- if I am correct about a pullback.
      Also, sometimes you get cross-sector reactions to any selloff- its just relative proportions of the selloff. But that is to be seen.

      Re the NAS H&S–typically H&S formations are after large moves–big downtrend in this case. We haven’t seen a prolonged downtrend on NAS. While your observation may be correct, its not typical to see a major bottom (H&S, double bottom, or cup/handle) until there has been a downtrend in place for a while. If the old highs are taken out, your observation would prove correct. I am simply looking at historical occurrences of big bottoming (or topping) patterns – which more often than not occur after big long trends.
      Good observation, lets see how it all plays out!

      Reply
  • Thanks for sharing your market insights, have done well on some telecom and staples related stocks in recent months!
    Just wondering if your view on gold and silver has changed recently since it’s falls into the commodities camp….

    Reply
    • Sonny–we reduced our exposure to precious metals but still hold some small amounts. Its been the dogs breakfast, for sure. The only reason I hold any exposure at all is the massive oversold signals I am getting, along with the massive sentiment contrarian signals that started to appear a few weeks ago. Gold has support near 1660 and silver near $23 so thats close enough to see if they hold. Would I buy more/ buy back in? Probably would consider it if I saw some technical strength off of those levels. Gold tends to be seasonally soft for the summer, so perhaps we wont see an opportunity until the fall. We shall see.

      Reply

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