Why do market tops tend to be distributional/rolling affairs? Could it be due, in part, to seasonal factors? Let's consider the two most recent market tops - 1998 through 2001; 2006 through 2008.
As both accompanying charts show (click images to enlarge), the seasonally weak period for stocks - May to November - was the point at which US large cap stocks stalled in their existing bull markets. The rate of change slowed as the multi-month sideways action enabled the moving averages (50 and 200 day*) to catch up to price. When price and the moving averages converge, the potential for a Mega Trend reversal exists. Should price break to the downside AND both moving averages go from sideways to down AND the 50 day crosses the 200 day AND both moving averages point downward, the distributional/rolling top is now complete and a trend reversal - from bull to bear - has occurred.
From a fundamental perspective, the distributional/rolling market action makes considerable sense as first and fourth quarter earnings periods tend to be more dramatic, while second and third quarter periods are more subdued. Moreover, from a market structure perspective, this also makes considerable sense as the first quarter is a strong funds flow period followed by a less robust new money flow in the second and third quarter. The fourth quarter has many cross currents (tax considerations being among them) and is more limited in providing meaningful insight.
Accordingly, and as noted in an earlier blog posting, market tops are distinct from market bottoms due to the psychological factors that come into play as opportunity cost is different than real cost. Opportunity cost produces a sense of comfort due to the wealth effect combined with a delusional state of mind regarding one's investment acumen as well as a delusional state of mind regarding the accuracy of equity analysts and economists in predicting the future, which begets a dismissive attitude among many an investor class as stocks rollover and change trends. Real cost, on the other hand, produces a distorted perspective among many an investor class regarding the cycles of markets and economies as the negative wealth effect from declining equity prices impacts both real economy behavior as well as many deflated egos. Hence the underpinnings for why one - tops - are rolling while the other - bottoms - are panicky.
Investment Strategy Implications
"Sell in May and go away" may be more than just some old Wall Street axiom. It may be an important clue as to why - and how - market tops are formed in their preferred distributional/rolling fashion. Therefore, for those fretting over an impending market decline (as in something beyond a pullback (5 to 10%) or a correction (10 to 20%)), recent history strongly implies that the current market environment is months away (at the earliest) from forming a top and a trend reversal. Therefore, Sell in May? Okay. Stay away? Sure. But make sure to check back in and see if 2013 produces yet another rolling market top.
*The charts are noted in weeks for clarity. Therefore, 50 days - 10 weeks; 200 days = 40 weeks.
Technical Tuesdays is a product of Blue Marble Research Advisory and illustrates selected elements of market intelligence analysis. Market intelligence analysis - along with fundamental and thematic analyses - form the three-legged stool of the analytical approach employed by Blue Marble Research Advisory.
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