Following the exuberance in January and subsequent corrective actions in February and March and now into April there has been a lot of speculation that markets may have topped in this cycle or are in the process of topping. While earnings are expected to hit record highs in 2018 due to the recent tax cuts much uncertainty has crept into markets due to concerns of reduced liquidity offered by central banks, rising rates into record debt levels, tariff policies emerging and previous bulletproof tech stocks such as $FB, $GOOGL and $AMZN entering a period of unfavorable news cycles, in some cases of their own making.
Given this backdrop I wanted to share some thoughts on market tops and analyze if the lessons of previous big market tops can be informative for our current markets.
Firstly, let’s look at the current situation. What made the first quarter notable was the strong outperformance of the Nasdaq versus other indices. Specifically we can observe that the Nasdaq made a new high in March while the $DJIA, for example, did not:
Notably we’ve seen a similar constellation before. If you are guessing the year 2000 you are guessing correctly. Not only did we see a similar event, but it also occurred during a comparable time frame:
New high for $NDX in March with a lower high in $DJIA. Given this similarity it seems fair to ponder if history will rhyme here.
But these charts on their own are far from conclusive.
One of the key technical patterns one can observe leading up to major market tops are weakening weekly RSI readings on new highs and we have seen this many times.
Here’s is the year 2000:
Note that toward the lead up to the final top markets underwent several larger corrections, including 1998, all of which followed a negative weekly RSI divergence, as did the final top. Indeed following the final top $SPX managed to squeeze in another lower high months later.
In 2007 we saw a similar set of events:
Then too we saw initial weakness at the beginning of the year following a very strong 2006 followed by further highs in the summer and fall.
Even in the lead up to the 1987 crash we can observe a similar development:
The common aspect in all of these: Expanding volatility, wider price ranges and negative RSI divergences and then eventually a lower high.
In short: These tops were processes.
How does this compare to now?
We have expanding volatility and price ranges, but we don’t yet have a negative divergence on the RSI and that is a notable deviation from the historical script.
While RSI divergences are standard technical factors for consideration there are also larger macro factors of interest and I’ve found industrial production and CPI of particular interest.
Here’s a chart I personally find fascinating. It’s a monthly chart that incorporates CPI data into the $SPX in form of a ratio. On this monthly chart below it too shows a very distinct pattern of negative RSI divergences for all the previous big market tops:
However, in addition to the RSI we can observe that this ratio needs to turn south before a meaningful top is in place.
As you can see the 2000 and 2007 tops were accompanied or followed by a break of a multi year trend line. While the ratio has turned south it has not yet broken its trend line.
What this chart also shows is how close markets came to the breaking of the trend in 2015 and 2016 which goes a long way to explain all this record central bank intervention we’ve witnessed. Markets were in serious trouble then.
But here’s the kicker: The trend line does need to be broken for a market top to be in. In both 1987 and 2000 the ratio peaked before the top.
However I need to reiterate: Every single one of these 4 tops had a negative RSI divergence to show on the ratio on the monthly chart. We don’t see that here. Yet.
One general word of caution about this chart: The data set is lagging and currently it shows the data as of March hence CPI is critically important to watch in the weeks and months ahead.
In this context another chart of interest: Industrial production versus $SPX:
The most recent market tops were accompanied by a downturn in industrial production. No such downturn can be observed quite yet. Again here we can observe how close markets were to topping in 2016 as industrial production turned sour, but the boost of artificial intervention has turned things around. For now.
The notable exception here: 1987. Industrial production continue to advance despite the crash in the stock market.
Several key takeaways:
Tops are generally processes that advertise trouble in advance in the form of negative divergences as they indicate weakness underneath the exuberant price action. Those are currently not in place. That doesn’t mean new market highs need to be made. As with 1987 one can envision a lower high, but new highs are historically very much a possibility given the historical record outlined.
Topping processes involve significant price expansion and volatility. This provides amble opportunity for flexible investors and traders to partake in the action in both directions especially as these processes tend to take months to unfold. Hence there’s no reason to be stubborn one way or the other, but rather embrace the ample available two way action.
The current market action is exhibiting elements of a market having entered a potential topping process yet several historical elements are still missing to confirm a top being in place, hence staying open minded and flexible may not be the worst course of action.
We’ll likely know more following this earnings season in April/May.