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Technical Tuesday - Beware: Market is Near a TOP

By Chris Rowe September 25, 2012 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

On many Tuesdays (the day I write for The Tycoon Report), before the article, I will list one or two "test your knowledge" technical analysis questions and after the article I'll list the answers.  I hope you find this fun and I hope it helps you make more trading profits.  Sometimes small bites can have a huge impact.

Technical Analysis Question of the Week:

Normally, which type of interest rates LEAD (change first), the short end (short-term rates) or long end (long-term rates)?

Why?

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You don't need to exit bullish positions yet.  You CERTAINLY don't need to be bearish here.  But there's one incredibly reliable indicator that says we are approaching dangerous territory. 

This indicator easily called:

  • the 2011 tops (before the "fiscal cliff/U.S. downgrade mini-crash")
  • the 2010 tops (February and April before the "flash crash")
  • both 2007 tops (July and October - all time stock market highs)
  • the 2000 top (which is actually the inflation adjusted all time high)

And so on and so on.  It also is great for calling bottoms, but that's a Tycoon Report for the future. 

What's best about the indicator is that it gives us a heads up LONG before we need to act.  Sometimes it's a couple of months before the stock market turns down, and sometimes it's weeks before it turns down.

But the point is, today the indicator is approaching market top territory. 

Every week Investors Intelligence has reviewed the sentiment of between 100 - 200 newsletters (depending on what year it was). 

When over 55% said they were bullish, we knew the bullish trade was what we, on Wall Street, used to call a "crowded trade".   It's a contrary indication. 

When too many investors are bullish, they have usually already put in whatever money that they have to put in the market.  That means less money to buy from future sellers (which means prices need to adjust lower before new buyers come in).  It also means those who like to take bearish bets (short-sellers) usually have plenty of ammunition (cash) to start initiating BEARISH positions by short-selling stocks.  

Also, newsletter writers are very much like individual investors, in that they become very excited bulls near market tops and overly negative near bottoms.  Most newsletter writers have little experience managing real money, and even those who have would fall into the mutual fund category (90% of them can't beat the S&P 500). 

When over 60% of those polled said they were bullish, that was an EXTREMELY contrary indication that we were almost certainly very close to or at a top.  This rarely happens, but it happened in twice in 1999, once in 2001 -- before the market lost another 43% -- in mid 2003, early 2004, early and late 2005 and late 2006 (see red arrows).

The very last time we saw over 60% bullish was at the October 2007 all-time high.  You can see that below.  The above chart goes to 2007 and the chart below picks up where that let off (overlapping 2007 a bit). 

The chart above has red lines comparing the stock market prices to the "over 60%" bullish sentiment.  But the chart below shows black lines any time the reading moved over 50%.

The horizontal green and blue shaded areas show 50% - 55% (green) and 55% - 60% (blue).  You'll notice today (2 charts down) we are at 54.2% -- only 0.8% below the danger territory of 55%!
 
Also notice in the above chart there's a blue squiggly line showing the percentage of polled newsletter writers that are bearish.  I circled in green when fewer than 20% were bearish, which is also dangerous.  Notice around those times that there's usually a large disparity between those that are bullish and those that are bearish. 

When the difference between those that are bullish and those that are bearish is large, it's dangerous.

For example:  If 55% of those polled are bullish and 25% are bearish, that's a 30 percentage point difference between the bulls and bears.

I'll extend the chart from above so you can see where we are today...

A larger than 30 percentage point difference is considered dangerous territory.  More than a 40 percentage point difference is considered very dangerous territory.  As you can see above, today the blue line shows bears near 25% and bulls near 55%, so there's a 30 percentage point difference. 

Again, we're not in outrageously bullish territory just yet, but we're on the dangerous line (and probably climbing).  

The chart below shows the difference between bulls and bears.  The horizontal green bar is from 30 - 35 percentage points, and the pink bar shows 35 - 40 percentage points.  Study the chart please. 

Final Thoughts

This is one of the only "leading indicators" out there, and it's the only "leading indicator" I use.  It's "leading" because it happens BEFORE prices.  In other words, the indicator is not based on something we know for sure -- like price.  It's based on mood/emotion/sentiment.

It can give us a signal a week ahead of time or a couple months ahead of time.  And if you want more than that, then you're asking for too much.  I'm selling crystal balls on the side behind my building in the parking lot if you want to stop by. 

THE SIGNAL:  The signal isn't seen until we see the indicator change direction.  Once it turns around (down) it's a "sell signal".  100 different indicators will give 100 different "signals" at 100 different times.  Sentiment is among the very first signal to be seen.

Two main types of sentiment signals are given.  One is when the "difference between bulls & bears" stops climbing and has reversed down.  The other is when the % of bulls stops climbing and reverses down.

When you see that happen, it will mean it's time to seriously consider taking bullish chips off the table -- and this is more of an "intermediate-term" (weeks to months) to "long-term" (months to years) indicator.  So when you get the signal you'll probably have PLENTY of time to act.  That's why it's one of my favorite indicators.  

Want to learn more about this and learn other powerful technical indicators and turn it all into a trading methodology? 

The next time we open up my course, "Technical Analysis Millionaire", you might take a peek!

In the meantime, I'll let you know when we get the sentiment Sell signal.  Stay tuned!

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Answer (to TA question from above the article):

The short end.

Because short term rates are more sensitive to trends in business conditions and changes in the Fed's monetary policy.  Decisions to change the level of inventories, for which a substantial amount of short-term credit is required, are made much faster than decisions to purchase plants and equipment, which form the basis for long-term corporate credit demands.

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