The Difference Between Market Tops and Bottoms

It is important for investors to understand a common characteristic of market tops that is quite different from market bottoms. Market bottoms are often V-shaped and sharp and the final low in indexes can come with a selling climax. Then it often takes many months for bases to develop and the real cream comes when those bases are broken out of on the upside on good volume, long after the low day is made. It is rare for a substantial percentage of stocks to make bottom and base-out and breakout before the final low in the indexes is made.

Not so with market tops usually. Lowry’s has done a great job of analyzing this recently. Tops are broad affairs that show a characteristic NARROWING in the numbers of stocks and industries that make new highs long before the day that the indexes make their final highs. It is not uncommon for 1/3 or more of stocks to have fallen by 20% or more, essentially already in bear markets before the top in indexes is reached, and for a majority of stocks to have already make their highs and have turned down by this point. Investors need to get out of most stocks before the final high is made to optimize results therefore.

Significant tops USUALLY, though certainly not always, are marked by a substantial divergence in the performance of various groups and stocks therefore. TM.com investors will remember the market period since 1998 as being a nearly nirvana environment for long-short strategies because we had huge pockets of old-industry stocks and groups in bear markets from 1998 on, while a narrowing list of new-industry stocks kept exploding to new highs – allowing profitable shorts and longs in breadth, all at the same time.

We HAVE had a narrowing of stocks and groups that are making new highs so far. A/D lines and new high/new low data as well as the number of groups making new highs show this narrowing process. BUT we have not had the divergence of 1998-2000 in this market. There are NOT a host of wonderful short-sale opportunities with group after group breaking down here. That MAY mean more of a soft-landing market environment than a major top environment in the making. In other words while it is clearly growing more and more important that investors seeking top returns FOCUS on the FEW TOP PERFORMING INDUSTRIES AND SECTORS, investors are not yet being wholesale slaughtered by holding the wrong industries and groups, absent a few exceptions. Even autos, one of the weakest groups since the end of 2003, seem to have a glimpse of hope of some better action.

Yet this week SOME groups are starting to breakdown a bit more – not so much in major topping formations yet, but substantial enough technical deterioration that exploratory shorts may be worth considering for aggressive traders, only to be added to upon substantial further evidence of breakdown. One example is housing stocks. The HGX housing index COULD be developing the right shoulder of a one-year head & shoulder top that would be confirmed by a high volume weak close under 225. On the daily charts, the uptrend line since the October lows was broken on volume this week. A breakdown on volume under 252 and under the 200 ma would add short-term evidence to suggest a longer-term top possible. XLY falling under 32 and RTH under 93 to accompany bearish action by housing stocks would give some credence to the concept of a housing slowdown impacting the consumer a-bit, something that macro data is starting to suggest is possible this year. So far retail and consumer discretionary groups have only LAGGED on the upside, but have not broken down. Utilities and bonds bear watching too and are in a similar technical condition. Therefore investors need to keep an eye out for breakdowns by key groups here. The more groups that actually breakdown, the more dangerous the market environment becomes. To paraphrase Joe Granville, don’t watch the water line of the top water in the bathtub, watch the suction of water at the bottom by the drain. The degree of breakdowns and weakness in the diverging weaker groups here may tell the tale of how toppy this market becomes and how much hedging and caution will be advised in 2006.

Of course the top groups are way extended and could correct sharply at any time. But the danger to the top groups may be evident from the action of the weaker groups. Let’s start watching for continuation and real breakdowns here closely to see if the market will limp through an economic slowdown of sorts in the US, or whether defensive action will become more and more necessary.

Our basic strategy of buying strictly only those stocks meeting our rigid criteria and selling short those doing the same on breakouts has had more new trades in the last month than in the six months prior, and so far these new trades are doing quite well.

Our model portfolio followed in TradingMarkets.com with specific entry/exit/ops levels from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in 2001, 7.58% in 2002, and we stopped specific recommendations up around 5% in May 2003 (strict following of our US only methodologies should have had portfolios up 17% for the year 2003) – all on worst drawdown of under 7%. This did not include our foreign stock recommendations that had spectacular performance in 2003.

Over the past week in our Top RS/EPS New Highs list published on TradingMarkets.com, we had readings of 135, 188, 168, 99, and 125 with 43 breakouts of 4+ week ranges, no valid trades and close calls in ORCT, SMSC, BNT, and PWAV. This week, our bottom RS/EPS New Lows recorded readings of 7, 4, 7, 10, and 11 with 4 breakdowns of 4+ week ranges, no valid trades and no close calls. The “model” portfolio of trades meeting criteria is now long TRAD, CIB, BOOM, GG, and RVSN. We’ve already suggested tightening up stops a bit in all of these, and profits should be locked in.

For those not familiar with our long/short strategies, we suggest you review my book The Hedge Fund Edge. Basically, we have rigorous criteria for potential long stocks that we call "up-fuel," as well as rigorous criteria for potential short stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published on TradingMarkets.com for breakouts of four-week or longer flags, or of valid cup-and-handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our down-fuel criteria that have valid breakdowns of four-plus-week flags or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is 100% long and 100% short (less aggressive investors stop at 50% long and 50% short). In early March of 2000, we took half-profits on nearly all positions and lightened up considerably as a sea of change in the new-economy/old-economy theme appeared to be upon us. We've been effectively defensive ever since, and did not get to a fully allocated long exposure even during the 2003 rally.

We have continued to suggest more than normal caution and milder than normal allocation to top global themes, and for investors to expect volatility and less than optimum markets. There are risks, the Fed is tightening, and a US slowdown may be materializing. Therefore cautious exposure, trading in and out with minor trends, is probably yet again the best approach to 2006. We are completing our “2006 Investment Roadmap” for traders and investors and hope to be able to offer this to TradingMarkets.com clients soon. We believe it is one of the most definitive guides to trading in the coming year and it includes our best analysis of global themes, trends, and expectations for the year as well as what to watch for changes in the environment. Ask for it from TradingMarkets.com!!

Mark Boucher