M is for
Part 1: Detecting a Market Top
"When the forgotten old dogs begin to bark and spearhead the
market's advance, the stock market is on its last feeble legs."
William J. O'Neil
Although conventional wisdom says market timing is a mug's game, William
O'Neil disagrees. "Recognizing when the market has hit a top or bottomed out is
50% of the whole complicated ballgame," he says.
He points out that it is "prudent or fashionable" for people "to say or
believe they are long-term investors...to stay fully invested through thick and
thin," and he notes that many institutions follow this policy. But he argues
that such a strategy is inflexible and can bring tragic results, "particularly
for individual investors". He recalls the disastrous bear market of 1973-1974 as
a warning. The average stock plunged 70% over that period as the Dow dipped 50%.
O'Neil's view is reflected in another common piece of investing lore - the
trend is your friend. In other words, don't fight the market. Whenever I hear
that phrase I think of the Bobby Fuller Four song - I fought the law and the law
won. Don't fight the market 'cuz the market will win!
So how can you recognize when the market is topping or bottoming? It isn't
easy as the April 26, 2000 issue of Hulbert's Financial Digest points out. Most
market timers were significantly more bearish in the Fall of 1999 just before
the market soared than they were in February just before the market collapsed.
These timers obviously missed the call on the late 1999 bull run and were less
concerned in early 2000 than one would have expected if they were accurate
Methods of predicting the market vary, but we'll consider only O'Neil's
It Comes Down to Economics
Although O'Neil doesn't state it in exactly these terms, it all comes down to
economics - the law of supply and demand. One should watch the daily price and
volume charts of the general market indexes, he says and learn to recognize key
telltale signs of an impending trend reversal.
He says that certain changes in volume and price indicate selling or
distribution. When institutions and professional investors start to sell, it
means a trend reversal is imminent.
He says most people miss these signs because they occur while the market is
still advancing. But the signs, he says, are clear. They are:
- The strong market leaders often sputter first, ahead of the general
- Some low priced, low quality speculative stocks begin to move up. (See
quote at top of this article!)
- The market averages have moved into new high ground.
- Market volume increases while the price level stays the same or rises
only marginally. The Dow shows stalling action.
- This usually occurs in the third to ninth day of the advance.
- There are often significant divergences between different market
These are the key factors, and O'Neil says one, notably the volume increase
while prices falter, occurs on just one or two days, so if you miss it, well,
you miss it. But we do get a second chance. After these indicators occur and the
market turns, O'Neil says the market will have an attempted bounce back. If the
first attempted rally fails, it is a sign that a market reversal is in progress.
How do we know a rally has failed? If the rally sputters in its third, fourth
or fifth day, or if the rally recovers less than half of the market drop, it is
a sign of market weakness.
Another sign is if the first market resurgence ends abruptly on the second
day with a strong opening in the morning but closing down at the closing bell.
Interest Rates & the Market
Everybody already knows this, but O'Neil emphasizes it, so let's say it
again. Increases in the Federal Reserve Discount Rate, particularly three in a
row, usually mark the beginnings of a bear market. 2000 was different. The
buoyant optimism after the feared Y2K bug proved to be ephemeral led the market
higher through a third increase. But the fourth increase eventually proved too
much. And there was a fifth one to boot.
O'Neil notes that an FRB rate increase in September 1987 led to the October
1987 crash. But rate increases are not primary indicators. They help confirm a
break. O'Neil notes there were three occasions in which a market reversal was
not predicted by a rate increase.
O'Neil makes a number of other points and it is recommended that readers
check out the book. It is well worth reading and goes into much more detail than
I can here.
That said, what do I make of O'Neil's observations? O'Neil includes several
charts in his book of selected market tops to illustrate his point about
increasing volume and faltering prices. And frankly, I find them to be far too
subtle for my poor brain to discern. If he hadn't put the arrows in the charts
pointing out the tops, I never would have known where they were. Really.
Moreover, O'Neil mentions a number of market tops to study to see his point
more clearly. He mentions: second week of September 1955, third week of November
1955, second week of April 1956, second week of August 1956 and so on through
December 1968, sometimes as many as three a year. That's a lot of tops, and
nearly all are intermediate short-term tops. It makes more sense to hang on to
stocks through all these little blips rather than to be constantly trading in
and out of the market.
I'm still of the opinion that it is extremely difficult, if not impossible,
to accurately predict broad market movements. This is, in my opinion, the most
difficult element of O'Neil's CANSLIM method to use effectively. And possibly,
the least useful.
I'm more inclined to try and predict the peaks of individual stocks than of
market averages. But that's for another article at another time.
But if you are interested in assessments of market conditions (and I do
believe they are worth looking at), there are a number of resources that do just
that. It's a lot easier than trying to figure it out yourself. These include a
website called Pitbull Investor which uses a CANSLIM approach and has a page
Stock Market Crash Index. This handy page indicates the current status
for major American indices as well as for various sectors. Canadian
investors will find Super Stock Picker's
Market Timing Indicator useful.