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Timing The Stock Market Top? Follow The Leadership

by: Macrotheme Capital Management LLC
Macrotheme Capital Management LLC
Medium-term horizon, macro, commodities, currencies

Markets do "climb the wall of worry".

Thus, the predictions based on negative news usually lead to being very early in predicting the stock market top.

The best timing tool is strictly following the market leadership - as long as the leaders rise, the stock market rises.

During the previous bull market, the S&P 500 Index (NYSEARCA:SPY) reached the top in October of 2007. Here is my experience in timing the top, along with the lessons learned, which can be applied in timing the current bull market:

In this article I clearly explained that there was a serious housing market bubble, which would cause a major financial crisis and a stock market crash. In fact, the homebuilders (NYSEARCA:XHB) bubble did burst in Fall of 2005 - and yet the broad stock market ignored the warnings and continued going up.

  • The yield curve indicator: The market consensus appeared to be that the crash in homebuilding stocks was isolated only to that industry and it would not cause a recession. Thus, I followed the yield curve indicator to asses the risk of a recession.

By that time, the yield curve had narrowed already from about 1.2% in January of 2005 to about 0.2% by Fall of 2005 - and this should have flashed the recession risks warnings. Nevertheless, the yield curve continued to narrow and eventually inverted by Spring of 2006 and stayed inverted - and yet the stock market continued going up.

  • The prediction in 2007: I realized that the broad market would continue to go up, as long as the leadership was strong, despite all macro warning signs. So, being active during the dot-com bubble, I followed the technology sector (NASDAQ:QQQ) (NYSEARCA:XLK), specifically the semiconductor stocks (NASDAQ:SOXX) (NYSEARCA:SMH). I noticed that the semiconductors were not following the uptrend, and wrote the article: Semiconductor stocks: Signaling a bear market?, which was published right at the stock market top in Fall of 2007. Here is the pdf:

  • The stock market top confirmation in 2008: Despite the underperformance of semiconductor stocks, the broad market was still led higher into the 2007 top by the "Four Horseman of Tech", specifically Apple (NASDAQ:AAPL), Research in Motion, Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOG). By March of 2008, these stocks significantly corrected, and I documented my analysis in the article The four horsemen of tech: Has another bubble burst? This, in fact, confirmed that we had a stock market top in place - even before the financial crisis hit in Fall of 2008.

Lessons learned and application to the current bull market

The broad stock market is likely to ignore the early recessionary warnings, political risks, industry-specific issues, and basically everything else, and just continue rising - as long as the leadership is strong. The major lesson I learned is to respect the wisdom: "The market climbs over the wall of worry."

Specifically, it is impossible to predict the stock market top in advance, while the stocks are still rising, even as fundamental indicators are deteriorating. Yes, a random prediction could always turn out to be correct, but the probability of making a consistent correct timing prediction is very low.

The stock market top can only be confirmed with some degree of certainty - only after the top has been formed. First, it is necessary to have a technical breakdown in the key leading stocks. Second, the technical breakdown in the leadership must be confirmed with fundamental indicators, such as the yield curve.

Thus, looking backwards, the 2008 article of Four Horseman was the most useful for the practical trading strategy, for either selling the longs or shorting the broad stock market.

Let's apply experience this to the current market:

First, currently the wall of worry seems to be getting pretty high, given the major geopolitical issues, domestic US political issues, issues related to Fed and broad monetary policy, etc. Yet, the stock market keeps reaching the new all-time highs.

More importantly, the broad stock market is currently led by the same stocks as in 2007: the semiconductors, Apple, Google, and Amazon. Research in Motion is out, but the new entrants in the so-called leadership FANG group include Facebook (NASDAQ:FB), and Netflix (NASDAQ:NFLX), and I would also add Tesla (NASDAQ:TSLA). So, let's narrow down and look at the chart for the semiconductors (SOXX):

The chart shows a very strong uptrend since mid-2016, even turning parabolic. Semiconductors significantly affect the the broad technology sector (QQQ). So, as long as the semis are rising, the broad stock market will continue to rise, despite all macro warnings.

Thus, given the uptrend in , anybody calling for a market top now is clearly a contrarian - and the risk of being an early contrarian is very high.

So, let's do a simple exercise - let's ignore all the news, and just focus on the semis. Once the technical picture of the semis has deteriorated, let's look at the yield curve. If the yield curve has significantly narrowed - the market top could be in place.

This strategy is called an early trend-following - you will miss the top, but the have a great opportunity to take advantage of a developing downtrend for a long time.

I will follow the semis and other leading stocks, as well as the yield curve, and update accordingly - so follow for real-time notifications.

Disclosure: I/we 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.