Investing
1/06/2014 @ 2:30PM
The Most Reliable Indicator Of An Approaching Market Top
Bert Dohmen, Contributor
In my research firm we specialize in advanced technical analysis of the financial markets. We use many technical indicators, measuring changes in money flows in and out of stocks, sectors and major indices, whether U.S. or international.
The only thing that can change the price of a stock, commodity or index is a change in the supply/demand relationship. Therefore, we must measure the change in money flow. When money has been flowing into a stock for many months, and then our indicators show that money flow has reversed, we know that a price top is near.
It may not be a long-term top, because some time later, renewed money flows come in, such as a large company stock buyback, surprising earnings announcements, a new product or CEO.
However, the most reliable indicator of risk—although not as precise as money flow—is sentiment. It won’t give you the exact day, week or even month of an important market turn. We use our other indicators for that. However, it does give you a great indication when the market is getting very vulnerable near a top, and a bargain near a bottom.
At market tops, there is almost unanimous bullish sentiment. The biggest money managers, the analysts most featured in the media, and the public are all bullish and declare that the bull market will continue for a long time. Caution is thrown to the wind. Money managers abandon the practice of keeping a cash cushion in their clients’ portfolios. They are fully invested.
Some may ask, why is this bullish sentiment not positive for the market? The answer is simple: when everyone is fully invested, there is no money left to drive stock prices higher. When finally the evidence says that perhaps the environment isn’t as great as thought, the selling starts. But money managers can’t buy more stocks at lower prices because they are already fully invested. Therefore, the decline continues, the selling accelerates, the bad news items become more frequent. And that is how bear markets start.
What is the situation now? Let’s look at some of the indication that we and some astute colleagues in our business have noted.
In our Wellington Letter we have pointed out a number of these indications that a market top is somewhere in the not-so-distant future.
The bears have become an almost extinct species. Everyone is bullish. The last time I saw this was in 2007, when I wrote my book, Prelude To Meltdown, which predicted that 2008 would see a monumental global credit crisis.
- The Investors Intelligence survey of investment advisors shows only 14.1% bears, the lowest since the 2007 bull market top. A huge 59.6% are bullish. Such numbers are rarely seen, and are indicative of an important top ahead. The ratio of bulls to bears is the highest in 11 years, as our colleague Alan Newman points out.
- The AAII (smaller investors group) shows the percentage of bulls at 55%, a number only exceeded once in this last four year bull market.
- The NAAIM (active money managers) indicate that their members are 98% invested, the highest on record.
- In 2013, we saw the most IPO’s since 2007 when the big bull market topped. Big IPO’s, like Hilton, indicate that the insiders are exiting by selling their stock to the less informed public and money managers.
- Chinese IPOs are back on Wall Street. Greed has now overcome the stench of fraud in Chinese firms traded in the US. Even many of the big U.S. hedge fund managers lost hundreds of millions of dollars but apparently are ready to jump back in.
- Some of the top performing stocks in late 2013 were selling at astronomical valuations. Some have no earnings. This is like the boom going into March 2000 before the dot com bubble burst. Twitter is selling at 66 times sales. Imagine: even if the firm had zero expenses, it would take you 66 years to get the purchase price back assuming to sales growth.
- We are hearing once again from analysts in the media: “The greatest danger is being out of the market.” That statement has always struck us as ridiculous. The way to make money in the markets is by buying when risk is low, i.e. when stocks are depressed, and selling when stocks are very high. After a four year bull market, and last year’s big performance, we ask, “are stocks high or low?”
- Investors are rushing into stocks like Twitter “because they don’t have earnings,” as Bob Prechter’s latest Elliott Wave Financial Forecast points out. We predicted this would happen as far back as last October, and reminded that this happened in late 1999-early 2000 before the crash. He also refers to the wild forecasts about how high the market will go, reminiscent of 1999-2000 when books predicted DOW 36,000, Dow 40,000 and higher. Instead, the markets collapsed. We are once again seeing such wild forecasts. Very few recognize that on an inflation-adjusted basis, the market today is still far from the year 2000 top.
- When you watch financial television, do you see anyone who is bearish on the market? They refer only to U.S. economic fundamentals, but totally ignore the big credit crunch in China that will infect all of Asia.
- “Securitized car loans” are being sold to investment funds just as subprime home loans (CD)’s) were sold to investors leading up to the crisis in 2008. Such loans are packaged in pools, and participations are sold around the world. The car loans are worse than home loans. Anyone who is breathing can qualify for a car loan now. Just bring a utility bill and your driver license.
- There is also a new boom in “covenant light” debt. Usually when bonds are sold, there has to be some collateral and compliance with minimum financial ratios. With “covenant light,” these requirements are kept to a minimum. Such sentiment which says “ignore risk” is like 2007, which imploded.
- Margin debt in stock portfolios is at a new, all-time high, just as it always is near a big market top. Sentiment is that it would be easy to reduce the debt if the market reverses. That’s what they thought in 2008, but the implosion was too fast.
That’s when companies buy their own stock in the market place. It reduces the number of shares outstanding, and thus boosts the earnings per share. It also boosts the stock price, which benefits management that has stock options. Therefore, could we say that the stock market rise is based on false assumptions and a foundation of quicksand?
The “distribution” process seems to have already started. That’s when the big, smart money managers, which includes the proprietary trading of the large Wall Street firms, sell even while the stock indices are rising. They can’t sell large amounts in a declining market. We detect that with our indicators.
Bottom line: There are many other measures of sentiment. Suffice it to say that everything indicates excessive bullish sentiment normally only seen near important market tops. That means most of the available money is invested. What is left to drive stocks up?
It doesn’t necessarily predict a top this week, or next or even next month. But it does say that the market is very vulnerable.
Our other advanced technical indicators will give us the specific timing. Over the past 36 years, they have allowed us to predict every bear market and often calling the market top within a day or two. Stay tuned. This will be a very exciting year.
Wishing you a healthy, happy, and successful 2014.
Bert Dohmen is president and founder of Dohmen Capital Research Group and editor of The Wellington Letter.
