Daily State Of The Markets: Looking For A Market Top Indicator?

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Includes: DIA, SPY
by: David Moenning

Good morning. Now that the DJIA has reached a new all-time high and the S&P 500 is getting close to doing so as well, it seems that the big topic in the press these days is picking the top. While history shows that new highs tend to lead to more new highs, the problem is the last time the Dow reached the Promised Land in 2007, the bears then started mauling everything in sight. And since 40%+ declines tend to stick with people for a while, everybody and your grandmother are looking for the top right now. In short, nobody wants to get fooled again.

Frankly, I can't blame anyone for being wary of the market at this juncture. After all, the market has taken at least one nasty spill during each and every calendar year since 2007. Therefore, anyone looking for something bad to happen in the near future does have history on their side. And since the drivers of the recent corrections (Europe and Washington) haven't exactly gone away, it isn't surprising that folks might be getting a little nervous at this stage of the game.

Normally, this is where I'd climb up on my soapbox and start preaching about staying in tune with what is happening in the market instead of listening to the guru's and their crystal ball-based prognostications. But since I gave that sermon as recently as yesterday, I should probably give it a rest for a while.

So, since everyone seems to be so sure that stocks are about to take a dive, this morning I thought I'd offer up an indicator that does a pretty good job of 'calling' big declines. And no, I'm not going to pitch you on my market-model approach again. But I will tell you that the indicator I'm going to describe is one of the inputs to our Market Environment Model.

But first, a couple caveats: The first is I would never suggest anyone use a single indicator to make any type of investment decision. Second, market "sentiment" indicators can be more than a little tricky and I do not have time or space this morning to do a thorough explanation of the ins and outs. However, I think this one indicator is worth your time. So let's get started.

Ned Davis is famous for saying, "Beware of the crowd at extremes." The idea is that when everyone is bullish (or bearish) they have already made their move in the market. This naturally leads to the question of: who is left to buy (or sell)? I'm guessing most everyone in the game these days has heard some version of this concept. And frankly, this in and of itself makes sentiment indicators less valuable - especially on a short-term basis.

But what you may not have heard about the idea of trying to gauge investor sentiment is that to be really effective, one needs to wait for sentiment to reverse after it has reached an extreme. You see, an extreme sentiment reading by itself isn't a sell signal (extreme readings can and often do become more extreme!). However, if a move is strong enough and lasts long enough for the sentiment indicators first reach an extreme and then start to reverse - now we've got something. In short, this is an indication that a move has gotten very crowded and is starting to go the other way.

Here's a specific indicator that you can follow to help you identify these situations. Each week Investor's Intelligence publishes the results of their sentiment survey. Respondents indicate whether they are bullish, bearish, or expecting a correction. Now, open up your favorite spreadsheet and create a column for bulls, a column for bears, and then a column that adds the two together. In the next column divide the number of bulls by the number of bulls plus bears. Then add one more column - to create an average of the number of bulls/bulls+bears over 10 weeks.

Here's the deal. When that 10-week average is above 69, history shows that since 1970, stocks tend to lose ground. (This is due to the fact that by the time the average gets this high, most people have already bought and the market is ripe for a correction.) But, on the other hand, when the 10-week average is below 53, stocks tend to perform quite well. (Again, this is due to the fact that when the 10 week average is extremely negative, most people have already sold).

But that's not the "signal" I first alluded to. So, here it is: When the 10-week average moves below 67, a sell signal is triggered. This scenario occurs after a period of extreme optimism has been achieved and then has reversed. While not perfect (what is?) only 2 of the 15 sell signals given since 1970 have been wrong (which, of course, means that 87% were right). And what's impressive is that this signal occurred before the declines seen in 1974, 1977, 1984, 1987, 1998, 2008, and 2011. As such, this is one indicator I like to check in on every once in a while.

What's the indicator saying right now, you ask? The bad news is that the current reading of the 10-week average is 69.5, which is above the level that is considered "extreme." The good news is that the 10-week average has not reversed and fallen back below 67 yet. If (and when) the 10-week does fall below 67, it would be an indication that risk is rising and that another encounter with the bears may be close at hand.

So, if you are going to insist on joining in on the game of picking the market top, I'd suggest waiting for this indicator to go negative first.

Turning to this morning ... With the DJIA sitting at fresh all-time highs, it appears that traders are content this morning to wait on word from the ECB's Draghi as well as next batch of economic data here at home. At this stage, the U.S. futures are a smidge below fair value and are following the movement of Europe's markets.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell ...

Major Foreign Markets:

- Shanghai: -0.99%

- Hong Kong: -0.03%

- Japan: +0.30%

- France: +0.31%

- Germany: +0.21%

- Italy: +0.21%

- Spain: +0.49%

- London: +0.30%

Crude Oil Futures: +$0.44 to $90.87

Gold: +$6.80 to $1581.70

Dollar: lower against the yen, euro and pound

10-Year Bond Yield: Currently trading at 1.94%

Stock Futures Ahead of Open in U.S. (relative to fair value):

- S&P 500: -0.76

- Dow Jones Industrial Average: -4

- NASDAQ Composite: -2.80

Thought For The Day ...

Once the game is over, the king and the pawn go back in the same box. -Italian Proverb

Positions in stocks mentioned: none