How to Identify Market Peaks

credit: dream designs from freedigitalphotos.net

credit: dream designs from freedigitalphotos.net



The following is a guest post from Troy who invests and trades in all sorts of markets and blogs at The Financial Economist. His blog blends investing strategies with economics, politics and history and I always learn something new. So it is definitely worth checking out.

As this bull market continues to climb, some are expecting things to peak and then decline. If that is true (which I am not sure), then at least you should be able to spot a market peak when it happens. On this post, I’m going to explain the characteristics of all market peaks, step by step.

Pre-Phase 1

This is the middle section of a bull market, when prices are going up nicely. There will be the occasional correction, but in general, things are looking good. The economic data is either in-line or slightly exceeding bullish expectations, and market prices are STEADILY going up (without too much volatility). Analysts are constantly raising their forecasts, but the crazed investor psychology that’s typical of bull market endings hasn’t creeped in yet..

Phase 1

This is when the market’s vertical ascent begins. Prices start to diverge from reality, and the market literally goes up day after day after day. Today it’s 2%, tomorrow it’s 1.5%, the next day it’s 2.6%. Any rational investor will start to wonder the substanability of this bull market.

The beginning of Phase 1 is when all the retail investors pile in, thereby pushing prices even higher. How do you know this? CNBC will post articles such as “records amount of cash flowing into risk-on assets like equities”. In the meantime, some seasoned investors are screaming “bubble!” and resolve to get out of the market before they expect the bull market to peak.

But this is where some of the seasoned, rational investors are wrong. They think that the market will peak soon – it won’t. The bull market still has room to run.

Phase 2

After the market’s first vertical ascent, there will be a period of 1-2 months with intense volatility. The market will swing back-and-forth violently for a while. The problem with this period of intense volatility is that it often looks like patterns that are characteristic of market peaks, such as the head-and-shoulders pattern. Thus, seeing this volatility some of the smart fund managers, investors, and traders will resolve to liquidate their bullish positions. And this is exactly where they’re wrong – this period of volatility is merely a continuation pattern, meaning that stocks still have one last up-movement.

Phase 3

After a period of volatility is always followed by a second vertical ascent. This is the final vertical ascent, ending with the bull market’s peak. CNBC will be brainwashed with bullishness, and investors will be using all sorts of explanations (excuses, actually) to justify the market’s high price (remember Apple earlier this year – all the justifications for why Apple should be a “trillion dollar company”).

I’d like to mention something else – if the market peak is predicted by everyone, then the market hasn’t peaked. The characteristic of all market peaks is that few can predict at price it will peak. Look back at silver for 2011. Everyone predicted silver would peak at $50 an ounce, and it did. Hence, the long term silver (and gold) bull market(s) are not over – few people should be able to predict the market peak.

Characteristics of the Peak

Here are the characteristics when the market has peaked.

When the market is close to its top, the previous leaders (securities that rose the most) will fall, whereas the previous laggards (securities that lagged behind the general market’s performance) will rise. When the third wave of market laggards become market leaders, the bull market is close to an end.

Near the end of a bull market, options prices will be record cheap. (Read this post if you’re not up on options.) This is because options is priced by volatility – the more volatile the market is, the cheaper options will get. In the end of a bull market, volatility is virtually non-existent because prices are going in one direction only – up.

RSI is a technical indicator that displays the market’s strength. I’m going to skip all the details about RSI because for the sake of this post, that’s not important. But what you should know is that generally speaking, when the market goes up, RSI will go up (because of bullish strength in the market). When the market goes down, RSI will go down (because of bearish strength in the market). However, sometimes divergences occur. A divergence is when the price goes up while RSI declines, which typically shouldn’t happen. This occurs near the end of bull markets because the bull market is losing steam. When a divergence occurs, I typically liquidate my bullish positions. Major warning signs go off in my head.

Plan B

Now let’s assume you missed the bull market’s peak, and you’re stuck with a bullish position. Here’s what you can do to mitigate your losses.

First of all, do not be in denial. Let me repeat this. I have seen investors who repeatedly deny the end of a bull market, only for the market to sink lower and lower and for their losses to grow bigger and bigger. Like a boss of mine used to say, “it is what it is”.

On the other hand, selling all you’ve got is a bad idea too. You want to sell at an opportune time that will decrease your losses. Following every market peak will come a very sharp and very quick correction. Prices will shoot up, but they will not exceed the previous market high. For savvy investors, this is your escape plan. But be quick, because this correction is very fast so if you miss it, then say your prayers.

If you have any questions or concerns, feel free to contact Troy at contact@thefinancialeconomist.com. Thanks for reading!

13 thoughts on “How to Identify Market Peaks

  1. Matt Becker

    “Markets can remain irrational longer than you can remain solvent.” -John Maynard Keynes

    Trying to time the market’s ups and downs is more likely to lose you money, and make you crazy, than make you money. Successful investors have a long-term strategy that expects market fluctuations without trying to time them. Before you rely on market-timing advice, first make sure you’ve kept track of that person’s predictions and seen how they’ve actually played out over multiple market cycles. Patterns from previous market cycles are not useful predictors for accurately timing future cycles.
    Matt Becker recently posted…Liebster Award!My Profile

      1. livingrichcheaply@gmail.com Post author

        I’ve always been fascinated by investing and the stock market. Granted there are some legendary investors and traders who are skilled at their craft, but I think for the average investor who’s job isn’t dedicated to researching the markets, it’s better to invest for the long term. Even for the pros, a lot of times you can make the right call but your timing might be off.

      2. Matt Becker

        The legendary investors were not market timers. They were simply great at picking great companies regardless of the market cycle.

        If you’re going to time the market, you have to not only be right on when to get out, but you have to again be right about when to get in. And you have to make both of those decisions correctly over and over again if you’re going to stay successful. The chances of doing that are extremely remote. And also remember that if you assume that the markets will rise over time, which is the working assumption for investing in the first place, then it’s worse to be out of the market during a rally than in during a crash.
        Matt Becker recently posted…More Proof That Insurance and Investing Don’t Play Well TogetherMy Profile

  2. Thomas | Your Daily Finance

    I say do what works for you. I have never tried to time the market but hear some say they know how to make money from doing so. I try to pick companies I believe and roll with the punches. I set my limit as the low I am willing to go and the price that I am going the shave some off the top. No matter there are always people making money in both a bear and bull markets. Nice post though.
    Thomas | Your Daily Finance recently posted…Paying For College with Federal Student LoansMy Profile

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