Identifying Tops and Bottoms
"The trend is your friend" is one of those Wall Street axioms that makes sense and should be followed. After all, the performance of a stock is greatly influenced by the performance of the market or a rising tide floats all boats, another Wall Street axiom. In fact the market trend is the most important factor to consider in your investing analysis. While the evening news reports on the Dow as representing the market, the professional investors are much more interested in the S&P 500 and the NASDAQ. Accurately gauging the market is not a matter of luck. Many of the biggest investing opportunities can be found right as the market begins a confirmed change in direction. There are clear telltale indicators that can help you identify market tops and bottoms.
So what do you look for to identify a change in the trend of the market. Please keep in mind that we are discussing significant trend trend changes and not the minor daily movements of the market.
There is no one proven method to always identify market tops, or bottoms for that matter. However, there are some good methods that have proven successful much of the time in the past. I also encourage you to read Market Cycles, as it describes the major cycles the market tends to experience. Unfortunately identifying a market top or bottom is as much art as it is a science. Fortunately, there are ways to help improve your odds.
At major market turns, you may see market indexes moving in different directions. The Dow, for instance, may be making new highs while the S&P 500 does not. It's also important to note if an index is advancing or declining at a much greater rate than another. For example, if the Dow rises 3% one day as the S&P 500 (the broader index) rises only 1%, it indicates the rally is not as broad or strong as it may appear. Also, is the volume getting stronger or is it at or below the 50 day moving average? In this case if the Dow advances on average or below average volume then there is not sufficient strength for the market to sustain its advance. This is why it's helpful to study market indexes in tandem, to more easily spot confirmations or divergences at key turning points.
However, not all market tops experience the diversion of the major indices. Historically, market tops can occur after the major market averages move into new high ground and show several days of large and increased volume with either poor price progress or actual declines in the averages. This is known as a blow off, like a steam engine blowing off excess steam.
If you are a technician, then you look for various chart patterns that indicate that the market is reversing its trend. Thomas Bulkowski's book Encyclopedia of Chart Patterns (Wiley Trading) lists the top ten bearish formations with the highest most likely declines. Using these these patterns gives you another way to help identify market tops.
So how do you decide which method to use to determine if the market is topping? The answer is you need to monitor all three closely to spot turning points. Each will give you some indication that a top is forming or near. So let's examine the recent market activity to see if we can identify the temporary top. Just keep in mind it is always easier with hindsight.
Generally, the NASDAQ leads the other market averages, so we will start with it first. Below is the weekly chart of the NASDAQ. Using this chart one can identify the top in the NASDAQ in early 2000 that is confirmed by the jump in volume. Also, the S&P 500 confirmed this top as shown on the the 2nd chart below. So why did so many people and analysts miss this trend change? Well, I believe they all were emotionally caught in their great stock picking prowess and were unable to change their strategies until much later. This is where your investing and trading discipline must be followed. Do not get emotionally involved with your stocks and portfolio. I also suggest you review the article on Market Cycles to get an overall perspective on the timing of changes in the market.
Now look at the cyclical bear market that began in the Fall of 2000 and ended in March 2003. It is easy to draw the down trend line observe the breakout in March 2003. The key to knowing that the cyclical bear market was over was the higher low that occurred in January 2003. Then in the next couple of months volume moved above its 50 week moving average. This showed market strength in the NASDAQ.
Now let's look at the cyclical bull market we experiencing currently. The weekly chart of the NASDAQ below also shows a key uptrend line and an important resistance level. As we can see the NASDAQ is near an important decision point on its longer term direction. We need to monitor this over the next several weeks. Keep in mind the NASDAQ generally leads the other averages when the trend changes direction.
Charts courtesy of Stockcharts.com
Using the weekly S&P 500 chart below we can identify the primary cyclical trend that needs to be monitored. I like to follow the S&P 500 as it is more closely monitored by the professionals than the DJIA. Let's first look at the specifics of the high achieved around October 2000. Note how the attempts at a new high are not supported by growth in volume. Rather there seems to be an actual decrease in volume as the new highs are established. This is a key indicator of a top is being established. Also, note that the S&P 500 reversed its trend after the NASDAQ.
Next look at the cyclical bear market that began in the Fall 2000 and ended in March 2003. Note how it also formed a higher low in early 2003 and then moved up nicely. However, here volume did not show a dramatic increase, giving one pause that we were in a new uptrend. If you read the piece on Market Cycles, you know that starting in the Fall of 2000 we entered a Secular Bear Market. Often, during bull market cycles within Secular Bear Markets, we will experience up trends without strong volume. I believe this is due to less than desirable economic strength and company fundamentals. The professional investors are treading carefully, trying not to over commit themselves to the market. Also, the US economy was experiencing a strong real estate market absorbing capital that would be available to buy stocks.
Next, note currently the S&P 500 is at its uptrend support level. This means that while we have had a tough May 2006, we still must wait to see if the price penetrates this uptrend or rebounds.
Hopefully, you now have a better idea how to identify market tops and bottoms. One cannot be precise in predicting a trend change, however, it is very important to monitor the market to assess what trend to follow. I will discuss more on identifying tops and bottoms in other Market Trends over time.