There are many examples of market blow-offs and subsequent crashes. It is a very difficult balancing act trying to decide whether to get out during the parabolic move, and possibly leaving huge gains on the table, or to hold on with the risk of overstaying the market and giving back much or all of the gains. There is no easy answer. However, many lessons can be learned from observing past large market moves and the inevitable crashes that followed. Gold in 1980 was a good case study, as was the Nasdaq blow-off in 2000. Many individual stocks make great studies as well, including many recently.
Is there a common characteristic that can warn of danger in a timely way? Does a bell ring at the top to suggest we stop acting like pigs and should take our profits? No, there isn't one bell that rings at the top, but there are many little warnings.
Sentiment indicators do try to give a warning when everyone seems to be on the same side of the trade. If almost all traders have the same opinion, and are all positioned on the same side of the market, who is left to buy or sell? This is obvious, but how do we measure it. Traders who agree on the current price, but disagree on value will characterize a healthy market that has room to move. If everyone agrees on both price and value, the market is sure to go the other way.
Most futures markets and stock indexes have many sentiment indicators that give an estimate of bullish or bearish bias. In addition, futures traders have the Commitment of Traders weekly report that separates the large traders, small traders, and commercial interests. The problem with these approaches is they are terrible for making timing decisions. Markets can stay overbought or oversold for months on end. Even extreme readings don't help when the market is in a sustained trend. And, I believe the market character has changed in recent years, and the sentiment indicators are becoming less and less useful. Everybody knows about them. What everybody already knows won't help much.
However, I still find one sentiment indicator that works almost perfectly. When a market has had an extended, directional move and if a market pundit is asked if the trend has possibly been pushed a bit too far, and the answer is "This time it's different," that's a sell signal. It is never different. It always looks different at the top because all the fundamentals that caused the previous price advance are now known, and reported by the media, and already in the price. What had caused prices to advance is now being learned, and now everything looks so bullish that it seems obvious that price has to now go up. But it already has gone up. It's now too late. The bus has not only left the station; it has already arrived at its destination.
I'm a visual person; therefore I view the ups and downs in the market visually, like a vehicle going up or down a hill. Imagine a bus going along a flat road with few passengers. Someone can easily get on the bus at each stop. This goes on for a few miles. The bus starts to climb a gradual hill, while more people get on at each stop. All of a sudden most of the seats are full. The hill the bus is climbing starts to get a bit steeper. It is a hot summer day. More and more passengers get in at each stop. Now it is standing room only, and the bus is climbing a very steep hill. It is struggling, trying to make it up the hill. A little bit of steam starts to come out of the engine compartment, but nobody notices. At each stop people keep climbing aboard. The passengers are oblivious to the straining of the bus. They are talking or reading. They just want to get to their destination. Now the bus is overcrowded and overheating. People are hanging out the windows and holding onto the outside of the bus. It keeps trying to get up the hill, barely moving at this point. One of the passengers asks a neighboring passenger if he thinks the bus will make it, citing an example of a previous bus trip where the bus broke down. The neighboring passenger replies "this time it's different, the bus was fixed since that trip." Right at that moment there is a big clunking sound with steam coming out of the engine. The ride is over. All the passengers get out in the worse possible location. Of course, the next day the bus is fixed and the whole process starts over.
So, back to markets and price charts and away from buses. There are some clues from the price charts, that in my opinion, are more direct and timely than watching sentiment. Divergences between prices making a new high, which are accompanied by lower oscillator readings, are an early warning. The problem is that there can be many divergences in a series before the market finally pays attention and turns around. In my experience, there will be a series of small divergences, and then one last push to a high accompanied by a larger divergence. Also, most likely going out to a larger time frame will show an overbought reading and possibly a divergence in that time frame as well.
Another clue is in the price bars themselves. There will often be a large bar up, or series of bars up, on unusually high volume. Often prices will accelerate into a parabolic curve on the last impulse move up. Other times will be the reverse; a large impulse move, followed by shallower and shallower impulses up. The former is probably a result of short covering, and the latter a result of traders just trying to keep the bull alive, despite declining momentum. Sometimes the conclusion will be left with one bar up there all by itself, with lower bars on each side. This is called an island reversal. This is usually a very timely and reliable signal when it occurs. But it is rare. And beware the retest. When perfect patterns appear, the market will often want to test one more time, just to make sure. Many times there will be upthrusts, or tall spikes, that fail, usually with the bars closing near their lows. The market often needs to retest these upthrust attempts many times, so don't be surprise to see a series of these upthrust bars at major peaks, often accompanied by declining volume, and declining oscillator readings. If prices fail to attract more buying and instead succeed in advertising for sellers, then it is best to leave the party on these failed attempts. It is hard to do because all the commentators and market letter gurus are saying the biggest gains are just ahead.
It is extremely difficult to pick a top. Markets can start to exhibit clues to a reversal, and then out of the blue the market takes off to the upside again. For more reliability, it is best to wait for a confirmation that a previous swing point low is taken out to confirm a trend change. However, in a runaway market this swing point is often far away and too much of the profit would be given back waiting for this point to be taken out.
There is no perfect rule for timing these events. Most of the time I get out too early, and if not I usually got out too late. It is easier to get out on strength, when the commentators on CNBC are jumping up and down with joy that the market, or stock, will never stop climbing because "this time it's different." It's far better to get out when everyone wants to buy, than when everyone is looking to sell. It is difficult psychologically to then watch the market climb ever higher without you being on board. It is even more difficult overstaying the trend and giving back much of what you had on paper.
Doug Tucker has a blog with daily commentary on stock indexes, precious metals, and other markets. There are many articles on technical analysis and indicator design and interpretation. To visit go to: http://tuckerreport.com
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