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
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
So how do you decide
which method to use to determine if the market is
topping? The answer is you need to monitor all
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
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
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
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
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
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