Is This It? What A Market Top Looks Like

Includes: DIA, QQQ, SPY
by: Mike Broudy

Are We at a Top?

I have read many articles recently that question whether or not the markets are at a top. The very prevalence of these articles, as well as general sentiment both by bloggers and reader comments makes me believe the opposite. Call me a contrarian. I have not seen many contributors or industry professionals call for a renewed bull market or recommended buying aggressively, and perhaps therein lies the key to this continued Bull Market. The S&P and Dow are already up nearly 9% and 10% respectively this year, and we are only at the first week of March.

So what does that mean? Is it a cause for alarm or a call to action? Plausibly it means one of two things. The first is that the market has gotten ahead of itself and is extended, as many experts have called for even since January. In the case of extended or overbought market, prices are likely to "correct," since we know the market rarely if ever moves in straight lines. It stands to reason that sooner or later the market will correct, however the severity and manner of the possible correction remains to be seen. The second possibility is that the market has much more work to do for the remainder of the year. By "work" I simply mean price advancement. Since we know that the January Barometer has a better than 7 out of 10 chance of predicting future gains for the remainder of the year after January (and nearly an 80% success rate for positive correlation including the month of January), the possibility exists that the market is just getting warmed up, however difficult that may be for some to believe.

Recently I wrote about the record-high in the Dow Jones Industrial Average and how this signaled a confirmed Dow Theory buy signal. The confirmation signal adds further support to the notion that the markets are likely to see continued price rises before they see significant declines. This does not mean that market declines will not occur in 2013 (they will) - it simply means that I feel the Primary Trend is up and will continue to remain up until the market shows signs of a top or a drastic catalyst occurs to derail the upwards bias that currently exists in this market. This brings me to my next point and the purpose of this article: what exactly does a top look like?

A Market Top

A market top has been defined in several ways. I will outline the classic and original definition of a market top as defined by Robert Edwards and John Magee in the "Bible" of Technical Analysis - Technical Analysis of Stock Trends. There are three phases of any Bull Market that are more or less consistent throughout modern history: accumulation, advance, and distribution at the top. The stages are outlined below.

Accumulation - Long-term investors sense that business is depressed but know that in the future the economy and sentiment will eventually turnaround. They accumulate shares at low prices expecting to lose at first but buy more over time.

Steady Advance - A steady market advance with increasing activity depicts an improved tone of business and a rising trend in corporate profits that attracts attention. This is the phase of a Bull Market that the "technical" trader makes the majority of his or her profits.

The Height - The market ultimately reaches a frenzy where the "public" flocks to it and nearly all of the financial news is good. Price advances not only frequently make the front pages but are spectacular. "Smart money" sells into the hands of the weak, capping off incredible profit from their accumulation in the beginning and middle phases of the Bull run.

At the height of a typical Bull Market activity is high and sentiment is wildly positive. A good portion of the general public who has been under invested or uninterested in the market until this point will now question whether or not to jump in full bore. They have seen that the market has gone up and naturally will want a piece of it going forward. The fear of missing out overtakes the fear of losing money. Typically, this is exactly when the market is extended. Some signs of an extended and "toppy" market include frequent upside gaps (wild enthusiasm) and low-priced, speculative issues that are bid up in quick fashion, despite being previously unwanted and not worthy of investor attention.

The previous description of a top is the "classic top" for a typical Bull Market according to Dow Theory. Today, nothing is certain except that this Bull Market is far from typical, however, history does tend to repeat itself (though slightly different each time). The financial news media plays an important role in facilitating a market top and also provides valuable information to the alert investor.

The Media

In order for the media to fulfill their role, they should generally reflect the opinions and views of their constituents. The more widespread the views are, the more prominently they will be featured. When Bill Gross said in August that the "Cult of Equity" was dying, this should have been a major green flag for contrarian investors. (Just like value investing was "dead" in 1999). That type of language is typically not seen at a market top. At a market top, more likely you will find someone calling for the Dow to be 36,000, or some other ridiculously in-character Bullish statement.

The news media will prominently display one-way sentiment near the peaks and lows of markets. For example, the research of Paul Macrae Montgomery shows that since 1923, Bullish cover-stories, are typically met with short-term advance but ultimately met with significant price reversal. Likewise, bearish cover-stories are met with short-term declines but one-year moves on average of 80% in the opposite direction. The real indicator of a top would likely be a very one-sided portrayal of the many positives the market has going for it in the financial media. This is something I have yet to see, though it is possible it could develop rapidly; keep your eyes open for increased bullish media plugs.

In Conclusion

While the market has been "hot" of late, it has not been extremely so. I do not feel as though somehow an extreme has been reached simply because the Dow broke a record milestone. In fact, this could open the door to renewed advance as I previously mentioned. The real indicator of a market top will be the sentiment of the public and the media going forward, as well as classic signs of a top such as heightened activity and extreme positive price moves. Also, watch for the market leaders to "roll over" and speculative high-flyers to well, fly high. When you can see all of the above happening in various areas of the market and the market as a whole, then you will know the end is near, though the final stages of a Bull Market have been known to persist for some time. Until that time, however, remain selective and continue investing along the path of least resistance. While the market is "ripe" for a pullback at these record levels, it is possible it could advance positively on a monthly basis for quite some time. The best approach is always selectivity, calculated asset allocation, and time diversification.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long several stocks in the market. Information is provided for educational purposes only.