The Signs Of Market Tops

The Signs Of Market Tops

Variant Perception, a US based research firm has published a thematic report on “understanding market tops” which we found interesting.

In their report they attempt to outline “how to recognise market tops as and when they occur” with their overall conclusion being that; “Today the market shows many of the elements that are present during market tops.”

The report goes into some detail on identifying the right signs to use and why, but can be more-broadly divided into the following categories: corporate, valuation, economic, market and sentiment which are then analysed separately. These categories are listed below and for the full report, a link can be found at the bottom of this blog for you to download.

From the report;

HIGHLIGHTS

Every market top is different, but they all have many elements in common. In 2007 banks and homebuilders had experienced a bubble. In 2000 internet stocks and large caps had experienced a bubble. In 1989 leveraged loans and LBOs had boomed and turned down. All of these were very different from each other, yet they shared similar characteristics.

Economic – Near market tops the economy is doing well but leading indicators are turning down. It is shocking for the average investor to realize that market tops don’t happen with bad economic data. They happen when employment is good and GDP growth is high. The downturn begins when the economy goes from being good to being not so good. Fortunately, leading economic indicators turn down before employment deteriorates and industrial production sags. This is why leading economic indicators are so important.

Corporate – CEOs are poor capital allocators when they use corporate cash and are a contrarian timing indicator. A CEO should issue company shares when they are overvalued and buy them back when they are undervalued. Likewise, a CEO should buy competitors when they are cheap and avoid overbidding when prices are too high. Unfortunately, most share buybacks and most mergers and acquisitions happen at high prices near market tops, and companies divest units and issue shares near market bottoms.

Insiders are much better at providing insight. CEOs are happy to squander shareholder money, but when it comes to their own cash, they are accurate market timers. When it comes to it, insiders are smart when it comes to their own money. IPOs surge near market tops as insiders sell out. Also, near market bottoms insiders buy their own stocks.

Sentiment – Sentiment is extreme near market tops and is generally useful as a contrary indicator. Near market tops, the bears have given up fighting the trend. Professional value-investors are discredited, and retail investors chase rapidly rising momentum stocks. Near market bottoms, it is impossible to find people who are bullish. The lesson is that investors should be greedy when others are fearful and fearful when others are greedy. This is easier said than done.

Valuation – Market prices reflect overreactions between euphoria and panic. Near market tops this means credit spreads are tight, low quality borrowers have access to capital, volatility is low, valuations are high and fad stocks do well. However, under the surface, problems emerge. Credit spreads start rising, volatility starts rising, and more and more stocks start making new lows. Markets are generally efficient, but they are not always efficient. This means that markets tend to under-price risk when investors are consumed by greed and they price in too much risk during panics.

The full report is an interesting read and can be accessed by filling out the form on this page. The report will subsequently be emailed to you. Whilst the analysis in this report largely lends itself to US markets, we are sure you will get some value out of it.

Russell Muldoon is the Portfolio Manager of The Montgomery [Private] Fund. To invest with Montgomery, find out more.