Can anyone time the top and the bottom of a stock market?

Kids, it's a great question, I'll try to answer....

I'm sure some can, I've yet to see it work over longer periods of times though.

Market tops.

Just when you think the good times can last forever.....

Invariably a topping process can take many many forms. This is mainly due to the players involved. 

For instance, in 1987, the major players used margin to buy stocks in the belief that they could buy at will and sell at a profit without worrying they were on borrowed funds. 

2000 saw a tech spending boom for Y2K, that people extrapolated to last a lifetime, therefore the tech stocks gathered pace and rose only to succumb to lack of future revenues and earnings. 

As for 2007, this was the time of Home leverage! Blame the lenders, blame the borrowers, either way the financial system was leveraged across the board.

Timing the actual top of any of these recent times was almost an impossibility. There were always clues, you just had to know where to find them. One such clue was in a previous post here, the yield curve. The most important clue though was the market itself.

What I look for: outside day reversals in the dominant market. 

An outside day is a higher high and a lower low on price in combination with increased volume. If the market is higher, it's an outside reversal higher. If the market is lower, it's an outside reversal lower. 

SPX 2007 High.

 

It's not a hard and fast rule, there are times when other considerations need to be taken in consultation. However it's a starting point. 

Market bottoms.

It really is darkest before the dawn.

There have been a couple of times when price action has been so bad, you almost were left laughing at the most extreme points. Consider the process starting at that point for marking a low. In 1987, October and December were awful.

1987 lows

 In 1990 the low was marked by Politicians not being able to prevent Gulf War I.

.

2002 low was the announcement of Afghanistan hostilities. For 2009, the actual price low was marked by an appalling unemployment report! You can see a pattern emerging. 

The price action from stocks was also very telling as at all points, further bad news was discounted and stocks actually rallied as further news was known.

So you see, with the benefit of hindsight and some stock market intelligence, being able to think clearly is of paramount importance.

Major tops and major lows can be seen quite clearly without pinpointing the exact days.

Consecutive down days to time the longs...

When we are in bull market mode, I like to use consecutive down days to guide my buying. There are usually 12-14 sets of 3 consecutive down days in any one year. 4 consecutive down days about 8, 5 days at 4 times. 6 consecutive down days number about 2. Any more than 6 consecutive down days risks a crash. 

In conjunction with these consecutive down days, you need to gauge some panic. I do this via the TICK index for NYSE stocks. The number needs to read -1300 or worse. Don't ask why, it just seems to work. This stacks the cards in your favor for entry levels. I use it frequently, it rarely let's me down. The trick is patience.
                                                   
TICK Index. -1500 is extreme

 

Important things to keep in mind:

A market can remain oversold for a longer time than you expect.

A market can remain overbought for far longer than you can anticipate.

Many experts try to employ a relative strength index, I've never seen one work well, much like an oversold/overbought condition.

Staying on a bull market...

This may sound ridiculous, but actually riding a bull market, is very difficult. At all points you have the threat of bad news derailing your long positions. When you inevitably sell something, it is no crime to re-enter the very same long at a higher price. That is part of managing your situation.

Trading a bear market....

Needless to say, that is as difficult as anything else, due to he fact they are shorter than bull markets and far more violent. The rallies within bear markets are sharp and fast. Many people have lost just by having to cover short positions in a violent bear market rally, only to see those same positions a day later significantly lower. You have to be consistently correct within a bear market. It's nearly impossible to be that correct for such a long period of time. If you try it, position size is the most important, risk very little capital.

Bull and bear markets do not only exist in equities, you can learn from others markets also, namely commodities (gold from 2001 to 2012) and other national markets outside the US. Being away from that action can teach you just as much, without having to listen to all the local noise (think Greece 2011). 

The stock market is a living and breathing creature, it is a difficult mistress. It neither cars for your intellect nor rewards your indiscretions. It cares not whether you are correct, only that the the stock prices themselves are correct. Keep your ego apart from your decisions, indiscipline will inevitably hurt! Everyday there are tricks to learn and, more importantly, re-learn. People will try and convince you there are trades everyday to take advantage of, this may be true, they just may not suit you and the way you trade. Be patient, then be brave.

Queen takes pawn

Why does the Yield curve matter?

Kids, you don't know what you don't know, until you know it!

Way back in the early 2000's a colleague pointed out the yield curve to me. What was the yield curve? The difference in yield between 2's and 10yr US Treasury debt. We discussed at length what it meant and how we might be able to use it. 

The Curve.

It is as cyclical as the market itself. Almost rhythmical. It has a habit of defining cycles. 

In essence it's primary use is for lending institutions to build balance sheets easily. Borrow short term money cheaply to lend it for a longer period, capturing the spread between the two yields. Simple enough. Remember the Fed are involved when it comes to a steepening or flattening curve.

Here is the longer term chart of yield curve vs SPX.

Steepening Vs Flattening Curve

So, as the yield curve steepens, you can bet your bottom dollar that financial institutions are making money. Conversely when the yield curve flattens it's likely that financial institutions are sacrificing some yield for more volume as the economy grows.

The cool part

When the yield curve finally moves from an inverted state and steepens for good, you can count the days to a stock market correction.  

I'll show you......

There are times that the yield curve has been INVERTED. This happens when 10yr yield is lower than 2yr yield, giving a negative carry (not being able to borrow short term at advantageous rates to lend longer term).

There are many and varied explanations as to why this happens, the most important thing to note is you are at the end of a bull market and are about to witness a bear market. The length of that Bear market changes according to circumstance. It's a strange sensation. You can see the yield curve steepen for good in 1990 that coincided with a correction in stocks, and in 2000 and, you guessed it, 2007!

1990

2000

2007

Implications of yield curve.

As you see flattening of the curve, there really isn't a concern as a goldilocks scenario exists in the markets. Once you enter an inverted phase, pressure starts on financial institutions to make money in other ways. They do this by increasing their risk profile for activities. At some point that inevitably comes unstuck. Call it bad financing of S&Ls, Internet incubators, Housing, Subprime!

This is a big red flag, do not attempt to outsmart the market or get caught up with a scenario that you lose because others are placing larger bets, what follows is a little chaos. You can see exactly what happens in 1987-1992, 2000-2002, 2007-2011.
As the yield curve is inverted, markets have a habit of rallying, the usual amount is about 6%. Use this time to build your cash positions, be at peace with your wins and your losses, do not over trade. There is an ill wind on the horizon. Timing this ill wind will be tricky, but there is one move that matters beyond any else.

WHEN THE YIELD CURVE FINALLY STEEPENS FROM AN INVERTED STATE, YOU CAN COUNT THE DAYS TO A CORRECTION.

Playing this on the short side can pay handsome dividends, however you will not sleep well as a bear has claws and all positions are subject to daily fluctuations that will force you out of your trades. You can also just be long cash which is a synthetic short as you expect cheaper prices.

These trends are very large and do not end without an awful lot of hardship and business's failing. 

This is your time to be humble and help those that are less fortunate than you. Many will ask for some help, offer it freely and with good grace. You had the benefit of reading this, they did not. 

Use the time of market uncertainty to assess its pulse. Use the steepening curve to understand that financial institutions will become healthy once more, no matter what the media says. When the market looks like it can't get any worse, likely doesn't! Lows have been marked by the starting of Wars, the inability of Governments to act or an Institution failing. The market will start discounting bad news and rally when everything points otherwise, be aware. This is a necessary healing process. You can benefit in the same way as before, allow the market to guide you on your journey.

Buy innovation, be brave. Some will not work out, keep your losses small, it is the gift of discipline. 

Never be afraid to re-enter the same trade, just understand your entry price. Some of the best companies in the world have suffered some short term setbacks.

Once the curve has steepened and the stock markets rally on bad news, you will notice something phenomenal! You are on the right side of the market and the Fed are helping you! That is a powerful friendship to have. 

Study the charts of leading stocks, they can guide you. No need to be too short term on your thinking, that is for others. Enjoy the peaks and troughs as the world really is a wonderful place. Keep your integrity, honour and discipline, it is yours alone.

Queen takes pawn.