'The Market Is Near A Top:' But Why?

 |  Includes: AAPL, FB, GMCR, LNKD, NFLX
by: Spencer Knight

Often times I find myself either listening to or reading brilliant, and at times, less than brilliant, analysts and financial professionals discussing topics of interest using industry buzz words. This is, however, an unfortunate circumstance.

What investors, and financial professionals, for that matter, need to focus on is the how and why particular trends occur. This enables readers and investors to create their own investment decisions and avoid following the herd. And let's face it, more often than not the herd underperforms. Remember that silly game where a cat's toy outperformed a money manager, a wealth manager, a stockbroker, and finance students?

With that in mind, one of Mark Hulbert's most recent article supports the argument that the U.S. equities markets are near a top. However, the issue is that he does not provide a great deal of qualitative date. Put more simply, Hulbert does not provide reasons as to why markets rise steeply before the bull dies and why the riskiest stocks shine before a market's peak.

These exclusions should be of importance for readers because, after all, when it comes to your money you should never, and I repeat, never, just take somebody's word for it. You should, however, take a look at the causes and the proposed effects in order to decide if the thesis makes logical sense. And in the end, nobody can control the financial markets anyway; well actually… I won't go there today, but the better you understand investment decisions the better sleep you will get at night

One Final Oorah for Equities

Hulbert's first "effect" is that markets tend to spike right before the bull dies. This rule can be applied not only to broad indexes, but also individual equities. Remember Apple (NASDAQ:AAPL)?

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And Netflix (NASDAQ:NFLX):

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And Green Mountain Coffee Roasters (NASDAQ:GMCR):

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And lastly the Nikkei is nowhere near its all-time highs:

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In any event, you get the point.

Before digressing too far, the first issue to address is to define a length of time. First and foremost, it is common that an asset or index goes through a brief correction prior to continuing a rally. The irony is that in the eyes of any long-term analysis, a period of 10 years can be considered a brief moment. This is important to note because it appears Hulbert is concerned with a long-term correction (i.e. the bull market dying) as opposed to the typical "breather" period before a bull market continues.

With that in mind, my concern is with regards to why markets spike right before the "bull" keels over. This phenomena has a lot more to do with behavioral finance than anything else. For instance, it is very easy for less experienced investors to purchase stocks that have had very strong momentum recently. In fact, there is a ton of research on the topic of momentum investing.

In any event, I have identified three reasons as to why markets spike right before the bull dies:

  1. Herd mentality- I mentioned this above, but now I will go into more detail. In the event of herd mentality, investors buy stocks that everyone else is buying. In most cases this occurs in stocks that are performing well and have been performing well. The thought process behind this is that everyone else can't be wrong so I will join them. Obviously this carries some inherent consequences, but tell that to everybody that bought Apple at the $10-$15 range.
  2. Availability of information- It is very easy for less experienced investors to avoid proper due diligence. After all, they work all day and find reading SEC reports mind bogglingly boring. So in lieu of this it is easy to read the headlines and agree. Facebook's (NASDAQ:FB) recent spike after a positive earnings report is a perfect example of this. In my opinion, Facebook's business is no better than it was two months ago, but the headlines say Facebook is doing well, so everybody needs to buy Facebook. And since the headline information is easily available then why not trust a large media outlet. When this is combined with herd behavior, you can get some very strong short-term spikes.
  3. Confirmation- Related to the availability of information is the idea that investors use headlines to confirm their intelligence. For instance, if you said Facebook's stock will take off last year, but you did not have the funds to invest, then you will likely buy now. First off, you will say, "see I told you so." And secondly you will immediately think that Facebook's stock price will only go higher. After all, you will think you were right, so that must mean you are a stock picking genius. Not sure I would invest my money based on that thought process, but it is difficult to shape human behavior.

There are many other psychological factors involved, but as you can see there is a reason for markets to spike right before they turn over. This reason is, in summation, based on the above behavioral examples; retail investment dollars flood the market hoping to catch some of the wave. And it does not help that these investors are using built in human thought processes as opposed to due diligence.

Buy Risky Or Don't Buy At All

Hulbert's second point is that the riskiest stocks tend to outperform before market tops. This is easy to understand because value stocks with high P/B ratios (i.e. the stock price is some multiple greater than the book price) are traded with more speculation; which gives these stocks a huge advantage over stocks that trade based on earnings.

But why does this happen? Referencing behavioral finance once again, one explanation is that after a very strong bull market investors that were not invested during the rally are seeking immediate satisfaction. For instance, if you know you missed about 100% returns by either selling near the bottom or buying yesterday, it is only human nature to attempt to get that money back. And, in order to make up for this miss, you will look for more speculative/value stocks, such as LinkedIn (NYSE:LNKD) and Facebook, in order to get higher returns.

If you do not agree, consider this; the whole penny stock and speculative biotech industries are based on the immediate satisfaction emotion that human beings have built into their brains.

Moreover, in the first half of 2013, small-cap stocks outperformed large-cap companies 19% to 7.5%, respectively. It may not be a rule of thumb, but small-cap companies tend to be liberally valued because investors are being compensated for taking on the added risk of a small company that has yet to prove itself. With that in mind, it should not be difficult to understand that a less experienced investor will look into the small-cap market in order to make up for lost time.

Does the Market Anticipate Economic Downturns?

The final note to make is with regards to Hulbert's belief that the stock market anticipates economic downturns, on average. He brings this topic up because the market's less than extreme P/E ratio of 18.7 does not indicate that the market is at a top; especially when compared to the 2000 P/E of 30. However, to say that the stock market anticipates economic downturns, on average, is not correct.

I must digress for a moment to define what I am considering an economic downturn. An economic downturn is the period between the business cycle's peak and trough. Obviously the actual business cycle is a conceptual tool; therefore in order to put some data behind it, I used monthly unemployment data and quarterly GDP data to decipher when the business cycle reached a peak. By analyzing both of these data entries in tandem, I was able to determine when the business cycle reached its peak.

According to my research of the last 11 recessions, the market, on average, moved in tandem with the economic data and did not anticipate an economic downturn. Put more simply, as the unemployment rate and GDP data worsened, the stock market weakened and eventually "collapsed" after the data proved the economy was no longer expanding. The two most obvious exceptions were the 1960 and 2001 recessions.

What To Expect From Here

I believe the long-term bull market is still intact. However, I am expecting a short-term shock/correction when the Fed does something; except, of course, in the event of increased asset purchases. Fortunately after some positive economic data this week we should see the Fed announce a tapering plan.

Another issue, that has become more apparent in recent weeks, is that as rates rise the housing market will weaken because loan rates will be higher and will cause fewer consumers to either seek loans or receive loans. And, not to be forgotten, the Affordable Care Act [ACA] will likely stunt economic growth. By how much, or how little, is yet to be seen and it is difficult to project.

Despite these serious issues this market needs a correction before I will feel confident in a sustainable longer-term rally; with the key word being sustainable. This correction will likely come about when the Dow Jones reaches 16,000 towards the end of the third quarter. This would indicate that a 1,500-2,000 point correction will occur during the first half of the fourth quarter. This will retest the 14,000 level as a floor and retest 15,000 as a resistance point as well. After this I expect to see the markets continue to rally through the first half of 2014 towards the 16,500-17,000 level.

Remember, despite my overly bullish sentiment, I do not feel confident with this market until a correction occurs. Since the economy is rolling along just fine, the kick in the butt needs to come from elsewhere. After a 1,500-2,000 point correction I will feel more comfortable with the market.

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.