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Is A Market Top Here?

What does a market top mean to you? If you are a day trader, the next day can have a meaningful effect on your bias and trades. With a focus on swing trading, then the next week or two will be important. If you’re an investor, then it’s those market tops that last months and fall significantly. Is this a big market top?

When we think about a larger market top it’s thought of as being broad based across the majority of sectors and it typically is. However, tops (small and large) occur can occur in varying degrees in sectors of the market and the widely followed indices like the S&P 500 and Nasdaq 100 mask the damage. We have seen a correction recently in the small cap stocks measured by the Russell 2000 and it’s this week it starting in the Semiconductor sector. Let’s look.

 

The Russell 2000 topped (short-term) three weeks ago when it tested its prior high (not shown) and it is now nearing an area of support. What it does at that support is likely to dictate what happens in stronger indices (S&P 500 and Nasdaq 100) that are still making higher highs and higher lows.

Historically, the Russell 2000 can lead other indices at turning points. Not all the time, but it’s worth monitoring it.  The reason for this is that these small cap stocks are more speculative and they can have significate moves. At a perceived market low, entering small cap stocks can provide the biggest bang (gains) for the buck. At a perceived market high, exiting small caps makes sense because they can drop significantly. What else is weak….

 

Last week, the Semiconductor index (SMH) broke down from a consolidation on increased volume. That break is short-term bearish, but SMH is close to its next support area. That being said, the index does not fully reflect the worst damage to some individual stocks within the index. Some have already dropped between 5 and almost 20 percent. What the Semiconductor index does at that next support level there is likely to have an effect on the stronger indices already mentioned.

A recovery in the Russell 2000 and Semiconductor index could help push the stronger indices to more new highs. While weakness could cause them to correct a bit lower within their uptrends.

Does this help us determine if a long-term, larger top is at hand? Not at all.

Actually, from a long-term point of view, there is nothing to suggest that the broader markets are close to a top. That seems to defy logic when some indices are close to being up 200%, some more than that since the 2009 low and any corrections has been minimal. What will cause this market to drop significantly?

Some would suggest an international event like what has been brewing in the Ukraine, a terrorist event or a change in political party. These can be a shock to the markets, but historically they won’t change things long-term. As mentioned, corrections are more meaningful depending on your time frame and when you entered the market. The latter being more psychological since even a minor correction from your point of entry is going cause you a concern.

From a very long-term point of view, the market measured by the Dow 30 (those stocks have changed over time) on a yearly logarithmic (percentage based) chart (not shown) suggests that the market will go up forever. A bold statement I agree, but there is nothing on that chart to suggest otherwise. Other than the 1929 to 1932 correction low, the other drops look like minor events.

Of course, that is easy to say when looking at a chart, but sitting through a 40 to 50% correction and seeing your wealth evaporate isn’t easy. And imagine having entered at the 2000 or 2007 high points; pain. For that reason, we want to determine as best as possible when such risk is getting closer. Closer being the key word, since it would be naive to think determining “the high” is likely. That futile exercise is for the entertainment of the Gann and Elliott wave enthusiasts.

 

We can look at and discuss many factors (some mentioned above) that may cause a big top happening. However, the one factor that takes many factors into it is the direction and spread (difference) between long-term and short-term interest rates. These will take into consideration the strength of the economy or the lack thereof, inflation, currency fluctuations, commodity prices and even political events like the change in balance of power to name a few.

For example, while the Obama Presidency – at this point – is considered to be among the worst. Yet the markets have risen significantly during it. Almost from the point he entered office. If his Presidency considered so bad, there must have been something else that was very positive at work?

If we consider that the market – through all information being available and reflected – is all knowing. The market knew from day one that nothing would happen to significantly improve the economy and it hasn’t. So the spread between long and short-term interest rates have stayed very bullish, which they were when he took office. The FED had been increasing liquidity for 2-years. What luck; the effect of the very bullish yield spread was just about to take hold.

At some point the spread will change. Maybe the tax laws will be changed, Republicans will take over the Senate next year, a new technology or who knows what and we don’t have to know. That’s what is great about this this information. At some point, something is going to happen that causes the spread between long and short-term interest rates to narrow. You only have to watch. The 10-yr. minus 5-yr. has narrowed a bit and is at its narrowest since the market low in 2009.

The spread historically is still bullish for the markets, but this small narrowing suggests the anticipation of change at some point. Maybe that the economy really will be improving; actually good (not that it’s not as bad now) and the FED begins to tighten (raise short-term interest rates) the monetary liquidity. Remember that markets anticipate. This might be why the U.S. Dollar has begun to rise; not much, but it is inching up. The EURO has been lower and now the British Pound is falling against the dollar.

At some point, short-term interest rates may rise above long-term (invert) and there will be a reason to believe that a significant market top is close at hand.

Is a market top here? Nothing we need to be concerned with long-term, but you have an insight what to look for. The best defense against major losses in the markets is a stock market education and I hope this Chart of the Week has helped with that. After defense comes offense and that too is based education and a plan. Learn more at this week’s Free Workshopsand in the community resources.