2013‘s stock market performance caught many analysts by surprise when the markets, measured by S&P 500, grew by more than 32%. Last year was recorded to be the best year for stocks since 1997. During the year, almost all major indices either reached or exceeded the 2007-2008 highs. Such a strong rally has many traders wondering if it will continue during 2014. We all know that markets move in cycles and periods of growth and prosperity, will at some stage, be followed by periods of contraction and panic. 

So the important question is how to tell if a contraction is going to occur and force markets lower? 

One of the main reasons we need to know the answer to the above question is that, there is an important correlation between equities and other major asset classes. So knowing how to correctly anticipate the stock market movements/correction can give traders a significant edge. Please refer to our “How Our Prop Traders Read The Markets“ article for more information about these relationships.  

This article is a very condensed version of what we at Trade View Investments monitor when searching for early warning signs of a market top/reversal.  

Monetary Policies

Monetary policies implemented by Central Banks have played an important role in helping the stock markets move higher. This was done by artificially keeping interest rates low and providing liquidity. At the moment any solid indication that the Fed will significantly reduce the liquidity or intending to allow interest rates to rise may force shares to go down. This is because traders are still nervous about the state of the US economy and many analysts believe that higher rates may not be a sustainable alternative.  

To monitor market’s conception about the rates we pay close attention to 2 year and 10 year bond yields. 

When looking at rates, you need to monitor the difference (spread) between the 10 year and the 2 year yields. A shrinking spread will usually have negative implications for stocks as a narrowing spread means the cost of capital in near term is relatively more expensive, which may result in liquidity to dry out and stocks to move lower.

 Valuations

Valuations are a measure of how much a stock is worth compared to the price. As Warren Buffet puts it, price is what you pay and value is what you get.

Valuations are important because they can also tell us how stocks are performing against their intrinsic values. They are also helpful to determine if stocks are overvalued (over bought) or undervalued (over sold) with regards to their historical levels. 

Price to Earnings ratio (P/E) is perhaps one of the most talked about ratios in the financial media. This indicator shows how expensive prices are relative to the earnings. Because earnings are subject to economic cycles, at Trade View we would rather use the so called Shiller P/E ratio which is calculated by dividing price by the 10 year average of earnings adjusted for inflation. The name “Shiller “refers to the Yale professor and noble prize winner Mr.Robert Shiller who publicized this indicator.  

The chart below shows the historical values of Shiller P/E ratio of the S&P adjusted for outliers. By adjusting for outliers we have taken out the top and the bottom 5% values to come to more realistic values. According to this chart, market PE is currently at 25 which is at a 44% premium to its long term historical average of 16. Also, based on historical readings, market has been on a PE of 25 or more only 6.7% of the times. In other words 93.3% of the times market P/E ratio has been below 25.  All of this means is that the market is overly expensive and current prices may not be sustainable for much longer.

Sentiment 

The third type of indicators that we look at is the “sentiment indicators“. These indicators measure the degree of investors fear and confidence. Markets usually reverse direction at the peak of a sentiment when most people are extremely bullish; markets will start to correct. This is because everyone who has invested most or all of their available capital ( as a result of being excessively bullish) ,there might not be anyone left to buy and push the prices higher .Therefore prices will start to decline .  

VIX or the volatility index is a well-known sentiment measure amongst market traders. VIX is mathematically designed to capture market conception of future volatilities. Traditionally when markets are going up, VIX  goes  down to reflect more confidence  and  bullishness. However this indicator reaches certain extreme lows markets will start to correct and panic builds in. To better understand this concept let’s have a look at the chart below. The orange line in this chart represents VIX and the black line represents S&P 500. Now consider how market has started to correct each time VIX has reached a low of 12.

In assessing sentiment indicators, one should note they are best used for short term trading strategies. Due to FED’s Quantitative Programs (QE) and their ongoing stimulus packages, some of the sentiment indicators have lost their effectiveness in recent times. But against this, we at Trade View Investment still think that a professional trader will need to keep track of market sentiment. 

Breadth

Breadth indicators are used to measure the strength of the trends. They achieve this by looking at the trend of the constituents of the market. Traders should be aware of these indicators as these measures provide valuable information about market reversals. 

A very insightful breadth indicator is the small cap performance against the large caps. Having higher sensitivities to the economic climate (or more precisely higher “betas”), small caps tend to outperform during strong and healthy market rallies. However when the market rallies are losing strength, we will see small caps under perform as investors turn to more solid and safer large cap stocks.

To better grasp the concept, let’s take a look at the chart below. The orange line in this chart represents the weekly  price of Russel 2000 Small cap index divided by S&P 500.When this line trends up( by showing higher highs and higher lows), the prevailing uptrend in the market (represented by the black line) is confirmed. For most of 2013, the market uptrend has been continuously supported by strong small caps. However since late October 2013, the orange line has failed to post higher highs to be in synch with S&P 500. This divergence can be alarming as it shows market participants are losing confidence in small caps which in turn can be a sign of less confidence in economic climate.

Conclusion 

Identifying a market top is a very delicate task and requires a great deal of analysis. What you saw in the above was only a handful of myriad of indicators that we constantly monitor. 

When looking for signs of market tops, you should be very careful not to confuse guides and symptoms with actual price action. Markets can remain stretched for longer than traders can survive. This means that your indicators may keep alerting you of a market top, but still, you may find prices going higher and higher before they finally drop. Strict risk management and application of multiple diverse models can help traders avoid calling a top too early. 

Even though we use a systematic approach to trading with mathematically based rules and models we do not try to pick the top and the bottom of market, we do however; try to understand what is going on behind the scenes to make sure that our systems are ahead of the curve.  The details of other indicators and their application are discussed by attending our In-House Systems Building Workshop.  

Quite recently some of our above categories are casting some serious doubts about the sustainability of current prices, therefore we believe it is time for traders to look at the above events and if they start to force a market panic then you need to be prepared to move quickly.

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