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Monday, November 12, 2012

Diagnosing a top

Every market top is somewhat different.  However, there are some things that happen every time.  As a bull market progresses the number of stocks going up thins out.  In the end, defensive indexes do well while economically sensitive indexes lag behind.  Lets see what we have in that department.

The first two charts are defensive sectors healthcare and utilities.  The last two charts are economically sensitive sectors industrials and transports.  The horizontal lines mark last year's highs.

We can see that these defensive sectors made new highs this year while these economically sensitive sectors did not.  This is a huge red flag.  The lagging sectors have had 18 months to do something positive to mess up this divergence, but have not done so.  I could have added the semiconductors, financials, basic materials, and oil to the lagging indexes part of the chart, but I did not want to make it too big.  None of those other indexes have climbed above their 2011 peaks.  This red flag is so big that for the life of me I do not understand why it does not bother people, LOL.  The market is screaming out loud at the top of its lungs that something is wrong here.  The divergences at the 2000 and 2007 tops were not this striking.  This market is prepared for a bear market.  It could not be any more obvious.  That is one part of my saying this top is technically weaker then the last two.  Here is the SPX chart with ADX.

I have shown this chart on the blog before.  Notice how much higher ADX was at the last two major tops.  Despite the magnitude of the rise in the index, it has no trend strength whatsoever.  The last major top with ADX low like this was in Jan. of 1973.   The end of that bear market was in late 1974, almost 2 years later and 48% lower.  In a secular bull market, the ADX rises during bull markets, and falls during bear markets. We have the opposite pattern.  ADX went up strongly in the last two bear markets and dropped during the
bulls.  In Secular bull vs bear market I showed how in 90 years of data ADX it clearly shows transitions between secular bull and bear markets.  It is saying we are not transitioning out of this secular bear market yet.  This indicator is showing this top is a lot weaker then the last two.

Where would a major top be without very bullish sentiment.  One way to judge sentiment is through margin debt.  The NYSE posts margin data here.  This is a monthly chart of SPX with the months marked when margin debt crossed above $300 billion.

The first green arrow was actually $278 billion, but that was the peak for that bull cycle.  Inflation has pushed the peak margin values over 300 or people are just genuinely more bullish then in 2000.  Notice that last year we hit the magic number of 300, but we did not make a major top.  We sold off 20%, but it was not a prolonged bear market.  I did not call for a major top in the yahoo groups because there were no divergences in the indexes.  If you look at the first chart again, you will see that all the economically sensitive indexes made new highs in 2011.  The market as a whole did not appear to look like a major top despite the very clear bearish weekly head and shoulder top pattern.  However, that is not the case this year.  The last two times the margin debt crossed above 300, we had at least a 20% sell off.  Will this time be different even though we are already in a recession?  I kind of doubt that.

The short term timing of when the actual last high occurs is the hardest part.  That is more art then science.  I was pretty green in 2000 having only started to trade in 1998.  I warned my family in Aug. of 2000 that I thought a 30-40% decline was coming some time in the next 12-18 months.   I was not quite bearish enough that time. At the end of Aug., I saw Maria Bartiromo on the floor of the NYSE telling everybody we better buy stocks now because when the big boys get back from summer vacation in Sept. they will be buying everything in sight.  It occurred to me that might be the sign we were at the top, LOL.  At the 2008 top, the key reversal day on Oct. 11 screamed at me that was the top.  I posted about it in the yahoo groups that night.  The market had been screaming top for a while, but that was the first time price did something that really looked like a top.  The two days at the time of the FED announcing QE3 this year stuck out at me for the huge number of new highs.  I wrote in the blog it looked like an upside capitulation to me.  To this date that high has not been exceeded.  I don't think that will happen anytime soon either, but we will see.

All major tops have a lot of warning signs.  The biggest problem in identifying tops is the time period that it can take for those warning signs to play out.  In the current case, this cyclical bull market peaked in the spring of 2011.  However, the major indexes did not top until Sept. of this year.  That is a long time and is a bit long historically.  Most tops form in the 6-9 month time frame.  In the market everything matters.  It matters that so many indexes have not taken out last year's high.  However, in the moment when the Dow, SPX, and the NASDAQ are making new highs and everybody is all excited, nobody notices the things that are wrong.  That is why most people miss the tops.  Repeat after me, everything matters, everything matters, everything matters.

Major bottoms do the same thing in reverse.  I will put together a look at the divergences at the 2009 bottom when time permits.

No top or bottom can ever be spotted by just looking at the major indexes.  They usually make their final highs and lows in relative proximity to each other.  You have to dig under the covers and see what the defensive and economically sensitive sectors are doing.  The final highs and lows usually have everybody on TV raging bulls or bears.  It is kind of comical to watch most of the time.  I guess this is part of what fascinates me about the market.  It does the same thing over and over again at  major turning points and people react the same wrong way over and over again.


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The information in this blog is provided for educational purposes only and is not to be construed as investment advice.