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5 "Tells" that the Stock Markets Are About to Reverse

Stocks Bull Market Topping

Stock-Markets / Stock Markets 2014 Jun 13, 2014 - 08:44 PM GMT

By: Zeal_LLC


The US stock markets’ Fed-driven melt-up has accelerated again in recent weeks, with a string of new nominal record highs.  This has reignited truly extraordinary levels of greed, euphoria, and complacency.  But for traders who have witnessed past bull toppings, there is an ominous sense of deja vu.  It turns out this past year’s strong stock-market action nearly perfectly matches that leading into the last bull-market top in 2007.

This shouldn’t be surprising at all, as topping signs abound.  The flagship S&P 500 stock index (symbol SPX, but trades as the mighty SPY ETF) has blasted an astounding 188.4% higher in the 63 months since today’s cyclical bull was born in despair in March 2009.  For the second half of this entire duration, the last 32 months, the SPX and SPY have not seen a single 10%+ correction.  This has bred euphoria.

The word “euphoria” is widely misunderstood by investors.  Most assume it means the stock markets are rocketing parabolic in a popular speculative mania.  But euphoria and manias are very different beasts, the former word simply means “a strong feeling of happiness, confidence, or well-being”.  That perfectly describes how the vast majority of investors feel about the stock markets today.  They really are euphoric.

Valuations, or how expensive stock prices are relative to underlying corporate profits, really emphasize the extremeness and irrationality of this excessively-positive sentiment.  At the end of last month, the 500 elite companies of the SPX had simple-average and market-capitalization-weighted-average trailing price-to-earnings ratios of 25.9x and 23.1x!  This is far beyond the 14x historical fair value, nearing 28x bubble territory.

Investors utterly loving today’s overextended and overvalued stock markets reminds me of 2007, when the last cyclical bull peaked.  Similar conditions existed, as the SPX had just enjoyed a large 101.5% bull market over the past 60 months.  There hadn’t been a correction in years, so sentiment was euphoric.  And stocks were very overvalued then too, with SPX simple-average and MCWA trailing P/Es of 23.1x and 21.3x.

What happened after that last stock-bull topping is what makes understanding today’s apparent stock-bull topping so critically important.  The S&P 500 and therefore SPY rolled over into a brutal cyclical bear that would ultimately bludgeon this mighty index 56.8% lower in just 17 months!  While that bear was exceptional, they still cut stock prices in half on average.  So stock-bull toppings are dangerous times to invest.

As a professional student of the markets and trader, I remember 2007’s stock-bull topping vividly.  It was a miserable time to be a contrarian, to bet against the crowd.  Everyone believed “this time it’s different”, that the forever-cyclical stock markets had somehow evolved to a new era of endless rallying.  Contrarian views were openly ridiculed and mocked, and it truly felt like the stock markets would keep on climbing forever.

At stock-bull toppings, everything seems perfect and super-bullish.  There are no storm clouds on the horizon, and it looks like clear sailing indefinitely.  Any economic data that seemingly supports the “all is well” notion is trumpeted, while any opposing data is rationalized away.  Mainstream individual investors finally start growing comfortable enough to buy stocks, with the late-bull low-volatility melt-up seducing them in.

While 2007’s last stock-bull topping felt just like today psychologically, I’ve been trying to recall exactly how the SPX/SPY price action looked on a tactical day-by-day basis.  Did we have this same low-volatility melt-up, with new highs being seen for weeks on end?  Were there few down days then too, with material selloffs nonexistent?  The closer this past year matches with 2007, the higher the odds we’re in a topping.

But unfortunately these aren’t easy periods to compare.  The SPX is much higher today than it was back in 2007, so not only can these episodes not share a common index-level axis but their percentage changes won’t be comparable.  On top of that, the calendar-year positioning of the last bull topping and recent weeks’ SPX highs don’t match either.  Both toppings have to be indexed to recast them in common terms for analysis.

So this first chart takes the last SPX stock-bull peak in October 2007, and this week’s latest SPX high, and indexes them both to 100 to make them perfectly comparable.  An index level of 90 in either era for example means the SPX was 10% lower than those highs.  And the date scale is replaced with months leading up to and after those highs.  The result is unequivocal, today’s stock markets look exactly like a bull topping.

There’s much to digest here, let’s start with the big picture.  Cyclical stock bulls are born out of cyclical stock bears, which leave stock prices undervalued in price-to-earnings-ratio terms.  The SPX and SPY are also very oversold after cyclical bears cut stock prices in half, so the early rallies out of those bear-market bottoms with peak despair are big and fast.  Stocks shoot out of their bear-market lows at steep trajectories.

But within a year or so, the easy gains have been won.  The stock markets are no longer oversold and have to start advancing based on fundamentals instead of sentiment.  The underlying economic outlook has to be good, and corporate profits have to be improving, to attract in additional investors.  And since the economy and earnings can only grow so fast, the rate of stock-market gains moderates considerably.

But the deep wounds from the preceding stock bears are still raw, so there is much skepticism in the middle stages of cyclical stock bulls.  Thus periodic major selloffs are common, from large pullbacks exceeding 7% to full-blown corrections beyond 10%.  These events are very healthy, as they rebalance sentiment away from the excessive greed and complacency rampant after major uplegs have surged higher.

All this is normal bull-market stuff, good for 100% gains doubling the preceding cyclical-bear lows.  I visualize cyclical-stock-bull index trajectories like a football professionally passed at a 45-degree upward angle.  After shooting up steeply from the quarterback’s hand, the football’s momentum soon starts to fade and its rate of ascent gets ever slower.  Its height peaks, and then it noses over to finish its parabolic arc.

The first two stages of cyclical stock bulls, the sharp initial post-bear oversold rallying followed by the normal slow mid-bull uplegs punctuated by major selloffs, follow this football trajectory.  But before their arcs peak, the third and final stage of cyclical bulls drives stock prices to break out to the upside.  These breakouts are readily evident above, the SPX surging over the normal bull arcs highlighted with large dashed arrows.

Cyclical bulls start accelerating again late in their lifespans, starting around the final quarter, because sentiment once again elbows out fundamentals as stock prices’ primary driver.  The longer a cyclical bull propels stocks higher, the more greedy, euphoric, and complacent investors become.  This leads to fewer major selloffs that become farther between, so the foolish perception that stock markets are riskless sets in.

Thus capital starts returning to stocks at an accelerated pace, forcing their prices up much faster than the underlying corporate earnings growth which expands their valuations.  And since a growing majority of smug investors no longer fear major selloffs, corrections vanish and pullbacks become smaller and smaller.  Investors feeling left behind are quick to buy the dips, countering selloffs before they rebalance sentiment.

The resulting late-stage-cyclical-bull stock-market action is readily evident above, a rather-steep low-volatility levitation.  Stock prices climb and climb, with far more up days than down days.  And though most of these daily rallies are nothing special, they add up to steep tight rises in stock prices.  As you can see in this chart, this pattern happened leading into the last stock-bull topping in 2007 and over the past year and a half.

One of the most fascinating things this stock-bull-topping comparison reveals is how similar the late-bull trajectories were in the final 15 months leading into 2007’s top and the past 15 months leading into today.  The SPX and SPY surged rapidly in steep late-bull uplegs, but there was relatively little volatility and major selloffs were essentially nonexistent.  I was surprised today’s topping tracks the last one so well.

Why?  This current bull is exceedingly massive thanks to the US Federal Reserve’s unprecedented QE3 debt monetizations and jawboning.  The dominant and likely sole reason the US stock markets took off in early 2013 and have surged ever since was the universal Fed-fostered belief among traders that the US central bank was effectively backstopping the stock markets.  If they sold off, it would be quick to ease further.

This has proved to be a powerful psychological force obliterating the prudent knowledge that stock markets are forever cyclical and don’t rise in a straight line forever.  It was surprising to see an eerily similar trajectory at the end of the last cyclical bull, which didn’t have the Fed printing money hand over fist.  But it did have the US house-price bubble, and the resulting false perception that our economy was booming.

Fueling terminal late-stage melt-ups in cyclical bull markets requires some external factor that is universally perceived as exceptionally bullish to attract in accelerated buying.  Investors need to have some way to rationalize their decisions to buy overvalued stocks high late in bull markets.  They really need to believe that “this time it’s different” because something new is happening that they think will fire a perpetual bull.

Zooming in on this same indexed comparison offers higher-resolution views of both the breakouts from normal healthy mid-stage bull markets and the final-stage terminal levitations.  Provocatively the final 15 months’ gains leading up to the end of the last cyclical bull were more extreme than today’s similar period in some ways.  The SPX was higher in indexed terms for most of that run, and witnessed even fewer pullbacks.

This ominous stock-bull-topping pattern is crystal-clear here.  Late-stage stock bulls with some powerful external psychological buying catalyst break out of their normal healthy ascent slopes to start levitating.  Major selloffs vanish as stock markets melt-up relentlessly.  This leads to extremely unbalanced trader sentiment, with greed, euphoria, and complacency growing ever more extreme with each passing week.

In merely 15 months or so, already high and overvalued stock prices can surge by 25% (running from a top-indexed level of 80 up to 100) as measured by SPX and SPY.  Investors start fearing being left behind more than anything else, so any selloffs are quickly short-circuited by buy-the-dippers flooding in.  This relentless buying pressure leads to the tight low-volatility terminal levitations seen on this chart.

But eventually buying exhaustion sets in.  Everyone willing to fight market history and buy high is already fully deployed.  And without significant new buying, the tired cyclical bull finally tops and rolls over into a new cyclical bear.  This final topping stage is marked by the extreme overvaluations that I mentioned above, as well as epic complacency.  This is best approximated with the definitive VIX fear gauge.

Just over a month ago I wrote about the VIX S&P 500 implied-volatility index warning of an impending major stock-market selloff.  You can get up to speed on the VIX and how it works in that recent essay.  For our purposes today, realize that just last week this VIX fear gauge fell to its lowest level of this entire cyclical bull.  In fact, it hadn’t been lower since early 2007 leading into the last cyclical bull’s topping!

An extremely-low VIX reveals extreme complacency, the opposite of fear.  The word complacency means “a feeling of contentment, especially when coupled with an unawareness of danger”.  Remember that the popular outlook for the stock markets is always the most bullish, always seems the most optimistic, right when stock bulls are topping.  The most dangerous time to buy stocks feels like the least dangerous!

That’s why studying and understanding market history is exceedingly important for investors.  The stock markets are forever cyclical, an endless parade of bulls followed by bears followed by bulls again.  No bull market runs forever, they all fail.  And that critical inflection point when they are running out of steam on the verge of rolling over into bears never feels bad at the time.  Cycle peaks offer no indication of impending change.

Think of the Earth’s seasons driven by its orbital mechanics.  In the midst of July’s triple-digit heat and blinding sun, it feels like winter will never come again.  But winter is still coming, we all know that.  The stock markets are the same way, bull-market summers lead to bear-market winters.  But since those stock-market cycles take far longer than our short seasonal cycles, they are difficult to perceive without diligent study.

Given the extreme size and duration of today’s cyclical stock bull, the extreme euphoria rampant among investors, and the extreme overvaluations of stock prices relative to underlying corporate earnings, there is no doubt we are in a major stock-bull-topping phase.  That has been readily evident since last year to every honest student of stock-market history.  These technical topping patterns are just icing on the cake.

Both the trajectories and percentage gains in SPX and SPY over the past 15 months have eerily matched the 15 months leading up into that last cyclical stock bull’s topping in October 2007.  In indexed terms to make them perfectly comparable, the past 15 months and the final 15 months of the last stock bull are almost interchangeable.  They are both low-volatility melt-ups, terminal levitations leading to bull toppings.

This has enormous life-changing implications for stock investors.  If Wall Street is right and this bull still has years left to run yet, the best gains you can hope to see in the major stock indexes are probably around 5% to 10% annually.  But if the contrarian view overwhelmingly supported by market history once again proves correct, then the elite stocks of SPX and SPY face losses approaching 50% in the coming years!

Is chasing minor gains late in an overextended mature cyclical bull really worth the serious risk of suffering catastrophic losses of half or more of your stock portfolio?  If this next cyclical bear unfolds over 2 years, and the cyclical bull after that runs for another 5 years, it will take 7 years just to return to breakeven when stock prices again match today’s topping levels.  Can you afford to throw away 7 years?

Prudent stock investors realize they need to study stock-market history and not fight the stock-market cycles.  They know after extreme runs they have to take the contrarian view and do the opposite of what is popular.  You can’t buy low and sell high if you succumb to herd-mentality groupthink, as stock prices are lowest after stock bears when everyone hates stocks and highest after bulls when everyone loves stocks.

At Zeal we are hardcore students of the markets who actually walk the contrarian walk.  Back in March 2009 when everyone thought the stock markets would continue plunging, I wrote the SPX was bottoming and a new cyclical bull was being born.  So our subscribers bought low.  In October 2011 after the biggest correction of this entire bull when everyone was calling for a new bear, I said that was an amazing buying opportunity and the stock bull was far from over.  I was right again.

Contrarian trading works, fighting the crowd is the only consistent way to buy low and sell high.  And now everyone thinks this stock bull will power higher for years more to come, but they are wrong again at another extreme.  Sadly the vast majority of stock investors, who spend way more time researching some new electronic gadget they covet than planning for their financial futures, are going to get slaughtered.

Don’t be one of them.  Learn to preserve and multiply your wealth the smart contrarian way.  We publish acclaimed weekly and monthly newsletters that will help you cultivate an essential contrarian perspective on the markets.  They draw on our decades of hard-won experience, knowledge, wisdom, and ongoing research to explain what is happening in the markets, why, and how to trade them with specific stocks.  Thriving in the stock markets requires thinking like a contrarian.  Subscribe today!

The bottom line is we are witnessing a stock-bull topping today.  In addition to extreme overvaluations and rampant euphoria, the stock markets have experienced a steep low-volatility melt-up in the past year and a half or so.  Technically this matches the price action leading into the end of the last cyclical stock bull perfectly.  The past 15 months in particular are nearly identical with the last 15 months of the last bull!

This is a menacing portent, as stock bulls are followed by stock bears which cut the headline indexes in half over a couple years or so.  Investors fooled by Wall Street’s false hype that bull markets last forever are going to get killed in this next bear.  Stock markets are forever cyclical, so it is foolish to buy high late in a massive bull market when topping signs abound.  It’s far wiser to sell high, and then buy low later.

Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at …

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit for more information.

Thoughts, comments, or flames? Fire away at . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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