Try to keep up
Like any moving object, the stock market tends to slow down before it changes direction. Rather than surging to a new high and then reversing, it tends to lose speed well before the actual turning point is reached. There are lots of ways to measure the market's speed or 'momentum', but one of the easiest to grasp is the relative strength index (RSI).
In 14 out of 15 bull markets since 1928, the weekly RSI has turned down in advance of the Dow Jones Industrial Average. The lone exception was in 1968, when price and momentum climaxed simultaneously. On average, the Dow has registered a peak reading of about 80 per cent some 70 weeks before the price top. However, on five occasions momentum has rolled over some 35 weeks before the Dow itself.
Verdict today: The US and Japanese markets' latest peak coincided with highs in weekly momentum. So, if history is any guide, there is room for further price gains to come before a major top happens. However, momentum has been waning now for some time in markets including London, much of continental Europe, Hong Kong and Brazil. Given the dominant influence of the US markets, however, momentum suggests the big top may be yet to come.
S&P 500 momentum
Public mood
The final stage of a bull run is when the man in the street gets most involved in the market. Having missed out on a lot of the gains on the way, he decides to make up for lost time and fill his boots. At the same time, canny investors who got in much earlier on take the opportunity to offload some of their holdings onto these late-comers.
Joseph Kennedy - a legendary Wall Street speculator of the early 20th century and JFK's dad - said he knew it was time to get out of equities in the 1920s when his shoe-shine boy started giving him stock tips. And everyone will remember the year 2000, when people who'd never bought or sold shares in their lives were ploughing savings into high-tech stocks they'd read about on internet bulletin boards.
The investment industry is not slow to take advantage of these late-stage bursts of popular enthusiasm. You can therefore expect to see a proliferation of advertising for the hottest packaged investments of the day on billboards and elsewhere. Approaching the last major top in 2007, there was a rash of publicity for newly launched commercial property funds – just as that market was sliding into crisis!
As every Tom, Dick and Harry starts taking an interest in the market, the mainstream media responds by beefing up its financial coverage. Stockbrokers and other experts are invited more frequently onto ordinary news programmes in order to explain the significance of the market passing some key milestone, say, the FTSE at 6000.
The front covers of magazines are a great indicator to watch for clues that sentiment towards a market has gone too far in one direction. Business Week famously ran a cover story entitled "The death of equities" in the early 1980s just as the most powerful bull market in modern history was about to charge. As well as keeping an eye on the shelves at your local newsagent, you can see analysis of front cover trends at www.schaffersresearch.com.
Verdict today: Public sentiment is a useful indicator but does not pretend to be a precise timing tool. Today, society's mood is clearly not as exuberant as it was in 2000, nor even in 2007. That said, after the spectacular gains in stocks over the last year and a bit, there are some signs of optimism that could backfire. Ominously, Newsweek magazine ran a cover proclaiming "America's back!" in April.
Muffled volumes
The strongest trends in the stock market are typically accompanied by lots of shares changing hands. That's because if lots of investors believe a trend is likely to continue, they put their money where their mouth is.
Looking back over time, the two most typical patterns during a bull market are that volumes either expand steadily throughout along with the trend, or that they dip mid-way during the trend before expanding again. In 13 of 15 bull runs over the last 80 years in the Dow, volumes peaked before the actual market. On the two other occasions, they peaked along with the market. On average, they have peaked 6 months in advance.
One reason that volumes peak before the market is because smart investors reduce the level of their activities in anticipation of a top.
Verdict today: Volumes have been declining throughout the bull run since March 2009 and have increased on sell-offs. This is unprecedented in 80 years of Dow history. A similar pattern is in evidence for other US indices, including the Nasdaq, as well as for the FTSE 100 and other European bourses. It does lend support to the view that the gain between March 2009 and April 2010 was a giant bear-market advance.
Nasdaq 100 volume
Dear oh dear
Most buy-and-hold investors look to valuations to decide if equities are at risk of topping or not. If they're dear, they are deemed more likely to fall. While this is logical enough, valuation is a blunt instrument when it comes to identifying market turning points. After all, just because the stock market is expensive, doesn't mean that it can't get even more so.
The level of the dividend yield is a good indicator of fundamental value. Unlike earnings, dividends can't be fiddled by companies. How much cash a company pays out to its shareholders is a matter of fact, not of accountants' opinion. On average, the dividend yield on the S&P 500 has averaged 2.9 per cent at major market tops. However, tops have occurred with a yield as high as 4.7 per cent and as low as 1.2 per cent.
A more useful message comes from comparing the dividend yield at tops with its level over the previous five years. Significant highs in the Dow have tended to be accompanied by a dividend yield that is four-fifths of its average level of the previous five years – see the line on the chart above. All tops since 1928 have occurred at ratios of 1.04 or lower.
Verdict today: Just before the latest highs in the market, the ratio of the dividend yield to its five-year average level was 0.9, which makes the S&P cheaper than it has been at the average top. However, peaks have occurred at when the ratio was higher than this, so we cannot say the market is totally unlikely to have topped from a valuation perspective.
Valuation at tops
Dow Theory
For more than a century, investors have used the Dow Theory to spot the switch from bull to bear markets. The theory involves comparing the behaviour of two of the oldest US stock indices, the Dow Jones Industrials and the Dow Jones Transports. When one index gives a sell signal, you are on guard to turn bearish if the other one follows suit.
Jack Schannep - the top Dow-theory practitioner of today - has researched its performance over a 54-year period. He found that the S&P 500 index tended to lose an average of 12.8 per cent over 5.8 months following a Dow-theory sell signal (to see the results of his study in detail, check out www.thedowtheory.com).
A classic example of a Dow-theory sell signal is when the Industrials and Transports reach new highs and then experience what looks like a mere correction to their uptrend. This might typically last between three weeks and three months, and retrace one-third to two-thirds of the preceding gains. The markets then rally, but fail to match their previous highs. They then break downwards through their first lows (see chart below).
Verdict today: Dow theorists often disagree about whether a particular signal has occurred or not. Some believe that the markets' sell-off in early May followed by their rebound and then the descent to new lows qualifies as a sell signal. Jack Schannep disagreed with this analysis, saying that the initial sell-off did not last long enough and that the indices had yet to form their first low. If they subsequently rally by a sufficient amount and then breach those lows, we will have bear confirmation.
Dow Theory
Market leadership
Certain indices tend to do consistently better than others during bull markets, and consistently worse during bear markets. The Nasdaq 100 is a great example of this. During the good times, exuberant investors pile into the racy technology stocks that dominate this index, but prefer the more balanced S&P 500 index during difficult times. So the relationship between these two is well worth watching.
The Nasdaq has been in a clear uptrend against the S&P since late 2008 (see the red line in the chart below). You can analyse the ratio between them just as you would a single share price. If a sharp reversal occurs, perhaps breaking a trendline in the process, it will provide confirmation of a likely top.
Verdict today: Although the S&P has strengthened versus the Nasdaq of late, the reversal hasn't so far been as big as one might expect if the market had topped.
And the jury says….
Compare the market today with market tops going back to the 1920s, and there is not enough evidence to say that the market has already topped. However, there are two big caveats. One is that this analysis could change rapidly, possibly within a few weeks. Another is that the rally of the past 13 months has been anything but typical, making comparisons with the past more difficult. So while we think there is enough left for one last charge, we'll also be watching for signs that the bull has lost its legs.
Nasdaq 100 volume
Are the tipsters tipping over?
The stance of American investment newsletter writers provides useful clues about the market's health. Since the early 1960s, Investors Intelligence (II) has published its 'Advisors' Sentiment' survey. In the short term, it is an excellent contrarian indicator. When advisers are strongly bullish or bearish, it usually pays to be on the opposite side.
However, not all advisers are dumb herd-followers by any means. The proportion of bullish newsletter writers has reliably peaked before the Dow did in every bull market going back to 1966. The number of bulls – expressed as a proportion of all those with an outright bullish or bearish view – climaxes on average around 79 per cent and around 30 weeks ahead of the market.
Admittedly, there is quite a lot of variation in the figures. Bullish sentiment has peaked as high as 90.9 per cent and as low as 68.5 per cent, and from a month to as long as a year-and-a-half in advance of the market. However, if sentiment has already reached an apparent peak at a high level some time ago, it clearly adds weight to the case for a top.
Verdict today: The 'Advisors' Sentiment' survey reached 77 per cent bullish back in January before falling back. Assuming this was the high for optimism in the current cycle, we would typically expect a top around August this year. But past experience also suggests it might occur any time from now until July 2011.
