After last week's steep decline (including the worst daily decline in almost 2 years), most investors wonder whether the market has topped. Of course Dow Jones (NYSEARCA:DIA) and S&P (NYSEARCA:SPY) are only 4% and 3%, respectively, off their all-time highs so the bullish side claims that nothing has changed and it is just a normal correction. However, there are some negative signs that are worth examining. Even worse, those who are waiting for the really bad news to show up, should keep in mind that this type of news shows up only after a great portion of the decline has materialized.
1. Steep decline on no news
There is not such a bad thing in the stock market as a steep decline on no significant news. Most markets fall off their top on no significant news, with most traders looking at the wrong direction. Of course one can mention some bad macro reports, such as the small number of new jobs and home starts and the deceleration of China, but the market has easily digested even worse macro news during its 5-year rally so I am not convinced that the decline was triggered by these reports.
I vividly remember at least three recent major tops on no news. First of all, in 2008, the price of crude oil suddenly started falling from its all-time record of $147 on no news. Then, in 2009, the Greek stock market began falling from its major top on no news too. When the default discussions showed up, the market had already lost about 1/3 of its value. Finally, in 2011, gold started falling from its all-time high on no news too.
2. Stage of the bull market
It is well known that bull markets have 3 stages:
A. The early (denial) phase, in which most investors are overwhelmed by the doomed atmosphere and hence consider it just a short-term correction.
B. The middle phase, in which the market climbs on a wall of worry.
C. The last phase, which is characterized by great euphoria. In the last phase most investors are sure that the market only goes north.
One can claim that we have only experienced the first two stages of this bull market so there remains the last one, which is typically characterized by very strong gains. I absolutely agree that we have not seen the euphoria phase yet, which definitely characterized the end of the two previous bull markets, in 2000 and 2007.
However, there may be a difference in this bull market. The last bear market was the most intense of the last 80 years so it may have indelibly hurt a great number of investors, who are reluctant to risk losing most of their capital once more. Therefore, the absence of the euphoria phase in this bull market may be due to the great wounds caused by the Great Recession of 2009.
3. The P/E phase
Another way to determine the stage of the bull market is to examine the behavior of the P/E ratio.
In the early phase of denial, the earnings keep deteriorating so the P/E ratio increases, which makes most investors believe that the bounce is only temporary.
In the middle phase, most of the capital appreciation of the stocks comes from the increase in their earnings so the expansion of P/E does not contribute much to the total gains.
On the other hand, in the last phase, almost all the gains in the stock market come from the expansion of P/E. Last year about half of the stock market gains came from the growth of real earnings so we have not reached the typical conditions of a market top yet, though the reservations of the previous point (stage of the bull market) still hold.
4. Buybacks, IPOs and margin debt
For reasons explained in detail in a previous article, the share buybacks are kept at a minimum near market bottoms and become maximum at market tops. Although this is very unfortunate for shareholders, it can be used to indicate whether we are near a market top. In Q3-2013, the total share repurchases amounted to $123 B, which is the highest level in this bull market, though very far from the record level of the previous bull market in 2007 ($180 B). Therefore, the amount of share repurchases is not something to worry about.
On the other hand, the IPOs are the most since the record level of 2000 so this is a negative sign, though it is not sufficient alone to call a market top.
However, the margin debt in the market is at an all-time high too, which is a very important reason to worry that we are near a major market top.
Based on the first two points, which I consider the strongest, I believe that the market will significantly decline from its top. Most investors are afraid that the major support of this bull market has been Fed's policy so now that the tapering has started most investors are afraid that the market may plunge. No-one apart from the really smart money knows how the market will be affected by the tapering but the fear itself is sufficient to trigger a self-feeding decline, particularly now that the margin debt is at its all-time high, thus causing a chain reaction.
Nevertheless, I believe that the decline will be much less severe than the previous one, which was experienced 6 years ago and was the most intense in the last 80 years. As the history has shown that there are never two extreme bear markets in a row, I believe that this bear market will be much less pronounced.
Even better, the big picture is that the S&P has traded in a limited range in the last 15 years and history has shown that it always manages to break to unprecedented highs every 15-25 years. I have described the big picture in a previous article. I believe that in the next 10-20 years the market will follow a path similar to 1980-2000, which of course will include some corrections or bear markets but the prevailing trend will be upward.
The big question after the above analysis is how to react in a market that is short-term and medium-term bearish but long-term bullish. The first step is to eliminate leverage by selling stocks bought on margin. If traders wait for a rebound in order to breakeven, they run the risk of facing great losses so they should not act based merely on hope.
Another prudent step is to close or trim the positions of cyclical stocks, particularly those that have medium to high P/E ratios. Even a moderate P/E of 14-16 in a cyclical stock can lead to losses of up to 50% in a year in a bear market due to the double effect of lower earnings and lower P/E in a bear market. To be sure, the legendary investor Peter Lynch has said that the fastest way to lose 50% of one's capital is to invest in a cyclical stock with a low P/E near the market top.
Finally, I recommend retaining full positions in value stocks that investors intend to hold for a long time, hopefully forever. These stocks should have a good record in the last two recessions (2000, 2008) and should trade at a reasonable valuation in order to be worth keeping. As the long-term picture is very bullish, I would not sell value stocks and I would not reduce my total exposure to stocks below 60%-80%.
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.