Editor’s note: In part I of Barry Ritholtz’s interview with award-winning technician Paul Desmond of Lowry’s Reports, Desmond discussed his research identifying market bottoms. Today, he talks about a more recent analytical paper that looks at how to identify market tops:
I just got an email from a friend who I had pinged before and mentioned I was speaking with you. He writes: ‘Tell him I loved his early work with the Dave Brubeck Quartet.’ I don’t know how many times you’ve heard that joke.
(Laughing) Oh, many, many times, yeah.
OK, all kidding aside, let’s talk a little more specifically about your most recent paper analyzing market tops. You’ve put forth the idea that markets at tops give very identifiable signals, that markets can be timed, that “buy-and-hold” really ignores a lot of information that comes at you. Is that a fair statement? .
Yes, it is very fair. I think the problem is there are an awful lot of investors who will say you can’t time the market.
Well they are saying ‘they’ can’t time the market. They’re not saying ‘you’ can’t time the market (laughs).
‘They’ can’t time the market. And I think what they are doing is looking at fundamental information. And if you are looking at fundamental information, I think you are absolutely right. You cannot time the market off of fundamental information, because the stock market operates off of expectations as to what is going to happen six months or nine months down the road. In other words, investors don’t buy stocks because of what they know today. They buy because of what they think they are going to know six months or nine months from now. So the market is always ahead of the economy. And as a result, if you are trying to look at fundamental information, you are always too late.
If you look at technical information, you can see signs of changes in investor psychology that are consistent from top to top. And that’s what this study that we just did shows very clearly, is that there is an extremely repetitive pattern that occurs at major market tops, and that pattern is one of selectivity.
Meaning the market becomes increasingly narrow as it progresses?
Exactly. There is a process that goes on from day to day, when investors begin to run out of money. They’ve invested everything that they’ve got to invest, and therefore they are out of the game of buying stocks. At that point, they are simply holding, expecting the prices will go higher.
Let me ask you a question about that, though, because the counter argument would be: Well, people get paid every other week, and they are making contributions to 401(k)s and IRAs. These days, there is some $3 trillion in money market accounts. Do they ever truly run out of money or is it more a matter that the sentiment begins to shift?
Sure. Well it occurs at a whole series of different levels. For example, some investors simply invest everything they’ve got and they’re out of money. Others will look at stocks and say, you know, I was enthusiastic about it when it was $20 but now it is $60, I’m not so enthusiastic. Others will say, my wife wants to take a vacation, so I have to spend the money on a vacation instead of investing in stocks.
Whatever the reasons are, the enthusiasm for continuing to put money into stocks begins to fade. And as it fades, the demand side of the equation diminishes, but the selling side begins to pick up, so sellers then are dominating in the market, and that is what tends to send prices down.
And this is not the way we tend to see bottoms, like a 90% downside day. Tops are really processes, while bottoms are a specific point?
Exactly. The major emotion that’s present at a top is one of complacency, where people are fully invested in stocks, or are invested as far as they are going to get, but they are convinced that prices are going to keep going forever, and therefore they are willing to ignore the initial market declines that come along from time to time. As they say, they are ‘in for the long term.’
At market bottoms, you have a completely different pattern in which the dominate emotion is fear and panic. And what we found at market bottoms, for example, was that in a typical major market bottom, you see a series of 90% downside days, 90% of all the volume, 90% of all the price changes are on the downside. Now the interesting thing that we found was that you can have a whole series of 90% downside days. During the 1973 and 1974 bear market, there were 15 90% downside days.
Over how long a period of time?
Over about 15 or 16 months.
So you don’t necessarily buy the first 90% down day.
No. And that is the really critical point about market bottoms, is that you can have signs of panic-selling and it doesn’t really mean anything. The only thing that will turn a market around and head it higher, is when buyers are wiling to step up to the plate and begin to buy.
The real signal of a major market bottom is to first see a series of 90% downside days, which say, investors are panicking, and in their panic, they are exhausting the desire to sell, because everybody that wanted to sell will have done it. But the key ingredient is to watch for a 90% upside day, indicating the prices have dropped low enough.
So you were saying the first 90% up day is a sign that sentiment has shifted dramatically.
That’s right.
And is that a buy signal?
I think the history of this indicator shows that if you were to wait for a series of 90% downside days followed by a 90% upside day and bought after that 90% upside day had been recorded, typically you would be buying at major market bottoms.
Top of the Charts
Let’s focus on the tops. We talked a little bit about breadth and we talked about how a top is a process, unlike the bottom being more or less a point. If investors are a little concerned, what should they specifically be looking for in order to see signs of a market top?
Well, if we were in the fall foliage season prior to winter, what we would tend to see in the trees up north, we’d start to see leaves dropping off the tree one at a time. And the stock market is very, very similar, that as you get into the latter stages of a bull market, individual stocks tend to peak out and begin to drop into their own individual bear markets, while there are still a lot of stocks continuing to advance.
As the bull market becomes more and more mature, a greater number of individual stocks tend to fall off the trees, so to speak, and drift to the ground, whereas the investment community is not watching the leaves, they are watching the indexes. They say, ‘gee, the Dow Jones Industrial Average has made a new high today.’
Let’s talk about that. You recently gave a presentation to a room of professionals where you asked them a series of questions. You were surprised by them, and they were surprised by what you told them. Would you talk about that?
Well, I had a group of professional portfolio managers that we were addressing, and I wanted to tell them about this new study that we had just done. And I asked them, ‘What percentage of stocks would you expect would be making new highs at the top day of the bull market?’ In other words, when the Dow Jones was making its absolute high, what percentage of stocks were also making new highs?
I asked, ‘How about 80%?’ and there were a lot of hands. Then I said, ‘How about 70%?’ and there were a slightly smaller number of hands. ‘How about 60%?’ and smaller number yet. And I think I took it down to about 50% or so.
And I said, ‘would you believe 6%?’ There was this complete silence in the room. Of the 14 major market tops, between 1929 and 2000, inclusive, when the Dow Jones Industrial Average reached its absolute peak, the average percentage of stocks also making new highs on that day was 5.98%.
How about within a few points of their highs?
Well we also looked at stocks within 2% or less of their highs. That number was 16.88% on average for these 14 occasions. Now those numbers range significantly, the lowest point was 6.23% up to a high of 22%. But that still meant that 80% of stocks were not making new highs at the same time the Dow Jones Industrial Average was at its high.
And you also point out that a significant number of stocks not only were not make making highs but had already dropped more than 20% from those highs.
Yes, that’s right. On average, the number of stocks making new highs along with the Dow was 5.98%, but the number of stocks that were off 20% or more from their highs was almost 22%. And in the 2000 case — which I thought was particularly interesting — as the Dow Jones Industrial Average made its all-time high on Jan. 14, 2000, 55.33% of stocks were already off 20% or more from their highs. So that meant that the bear market had really started substantially before, at least many months before, the Dow Jones Industrial Average reached its peak.
Typically, I think most investors have a kind of a dream in the back of their minds that wouldn’t it be a terrific trick to have sold out on the absolute top day of a bull market. The bragging rights from that would last a lifetime. But the actual facts are if you were to have sold out on the absolute top day of bull markets over the last 100 years, your portfolio would on average be off probably 10% or more and 20% to 22% of your portfolio would already be off 20% or more — just as the Dow Jones Industrial Average was just reaching its peak.
Well, after 2000, I’ll bet there were plenty of people who would be thrilled to be off only 10% or 20%, given the destruction we saw on the Nasdaq after that.
Absolutely.
So, it sounds like this is really a fascinating way not only to look for market tops, but to think about market tops. Meaning that, when the market is actually topping out by these narrow indexes — be it the Dow, or the Nasdaq — it really means that a lot of other stocks have already started to fall off the trees, as you suggested. And the highest profiled, best-known stocks are the ones that are continuing to go up, and that is reflected in both the breadth data and the new 52-week high data. Is that a fair way to describe it?
That is exactly right.
To an individual investor who may be reading this, is there an indicator they can follow? The dominant theme of the chatter seems to be pretty bullish lately. If people want to know if the market is in a topping process, what would you suggest they look at? Meaning, what would you advise someone’s mother-in-law? When do they throw in the towel and wait for a sunnier day, to mix metaphors?
I think the first thing an investor has to do is realize that when the news gets so good, that it just can’t get much better, that that is the time to look out, to be careful. Major market bottoms are always surrounded by enormous amount of bad news, and yet that is the right time to be buying.
You have to be willing to buy in the face of bad news. By the same token, at market tops, the news is dominated by good news, and that is the time to watch out because if the news can’t get any better then all it can do is get worse.
How would you describe the news environment we are in? I thought the news was pretty cheery in the fourth quarter, but we have started to see some cracks in the facade this quarter.
Well, I think generally the news is pretty positive. People are convinced that the Feds are about to stop raising rates, the unemployment numbers are down substantially and the politicians are out promoting the idea that the economy is stronger than it has been for a long time. And generally the news is good.
Outside of the geopolitics out of Korea, or Iran, or Iraq, or Israel, or Russia or China, but domestically, you think generally the tenor is pretty positive. If that is the case, what are you seeing in terms of the advance/decline line? What are you seeing in terms of new 52-week highs at this point?
Well, number one, one of the things you want to watch as a long-term indicator is the number of stocks reaching new highs. And usually that is recorded in the paper as new 52-week highs. And that indicator reached its peak back in July of 2005 and has been diminishing since that time.
Now that is your proprietary operating company [list], and not the full NYSE?
Yes, that is right. But even [with] the full list of NYSE-traded stocks, we show pretty much that same pattern. Distortions will come in periods like now where bonds are tending to be a little bit stronger than they were from time to time. But still even with the unadjusted numbers, the number of stocks making highs peaked quite some time ago, and each rally since then has tended to be a little weaker than the previous rally. So we made two peaks in January that were about 150 new highs per day, whereas those numbers in July of 2005 were in the 225 range. So you see they have dried up substantially and we think they are going to continue to do that. I was looking at [Tuesday’s] data a little bit earlier, and whereas we had been running several hundred stocks making new highs per day, today we have 103.
As we are speaking [on Tuesday], we are up 140 on the Dow. Are you suggesting, considering the strength of today’s pop — the Nasdaq is up over 1%, straight across the board, the NDX, the S&P, the Nasdaq, the Dow, they are all up over 1% — that we are seeing a modest amount of 52-week highs, given that across-the-board strength?
Absolutely. Yes.
So according to your analysis of bull-market tops, where do you think we are in the cycle. Are we close to the top, getting near the top? Weeks or months away? What’s your general take, without scaring the bejesus out of everybody?
We are well in the process of forming a top, but we are not to the final stage of this thing yet.
If we were to measure the final top, based on the Dow Jones Industrial Average, — which is not the best way to judge a bull-market top — it is very possible that the Dow has not made its final high yet.
This past week, we took a look at the Dow Jones Industrial Average stocks, the 30 component stocks of the Dow, and what we found was that there were, based on our way of analyzing individual stocks, three of the 30 stocks in strong uptrend patterns — just 10%. And 20 out of the 30 stocks were in well-defined downtrend patterns. So you can see the selectivity that is present there, with 3 of the 30 stocks in uptrends, 20 in well-defined downtrends.
That same type of selectivity is occurring across the broad list [of stocks] as well. Not to the same extent, but it is occurring. And so we think that it is possible that the final highs in the major market averages have not occurred yet, but that a lot of individual stocks have already rolled over into their own bear markets.
Now investors generally don’t buy the market averages, they buy individual stocks. So what we are telling people is that you have got to be watching your own individual stocks at this stage of an old bull market. What you should be doing is holding onto the strongest issues in a portfolio but culling out any stocks that are failing to participate in rallies. So for example, today, an investor ought to be going back through his portfolio and saying, ‘Well, the Dow was up 140 points today, did my stocks participate?’ And if they didn’t, that might be a sign that for that individual stock, the bull market is at or near its end and greater caution should be taken in holding onto to those kinds of stocks.
Let me personalize this a little bit, [in] your own retirement account … are you still primarily long? Have you moved to cash? What are you doing personally?
I tend to use ETFs more than individual stocks, because my job is to take care of my clients’ portfolios rather than my own, and ETFs make it much simpler to manage portfolios. So I am still heavily invested in mid-cap stocks. Everything else, every other area, I have been out of for quite some time.
So I can assume you are not buying into, ‘Hey, this is the year of the big-cap?’
Oh, no. We have heard that repeatedly.
Five years running.
But when we go through and look at the evidence of, is there any signs of actual buying enthusiasm present there, what we see is that investors are absolutely ignoring the call to go out and buy big-cap stocks. Investors simply are not moving in that area. And part of that is a reflection of what I just pointed out, with the weakness in the Dow Jones stocks.
Even on a plus-140 point day, you still see, based on the trends of the majority of the Dow, that they are not really looking particularly healthy?
No, they are not looking healthy at all.
Now, I know you don’t do forecasting or make predictions. You think that sort of stuff is folly. But the question that I know people are going to ask me is, ‘Well if Paul Desmond thinks we are in the process of topping, how much further is this going to go?’ How much more time do we have to start culling individual names? Can this process take another year, or are we looking for significant trouble sometime in 2006?
Our expectation is for a sharp decline throughout most of 2006 that may well reach its low sometime around September of October.
The traditional months for those sorts of things.
Yes, those are just the most common months historically, more bottoms occur in the September-October period than at any other time.
I have Jeff Hirsch’s Stock Trader’s Almanac right on my desk, and they’ve looked at that data on a calendar basis, nine ways from Sunday, and most people think it is October. September seems to be pretty bad also. So, in terms of positioning, you would continue to stay with mid-caps until they show signs of rolling over.
Well, I think it is entirely possible that we are seeing the start of the rolling-over period now. In other words, this rally that’s beginning here in the last two days, will be an important test of strength of this bull market. If the majority of mid-cap stocks do not get back to their highs along with the market averages, then that would be a sign that the mid-caps have started to rollover, and I would be anxious to cut back on my holdings of mid-caps at that point.
So is it safe to say, to go back to your … New England metaphor: The leaves have already changed colors, we are starting to see leaves drop and it is a matter of time before they all hit the ground. Is that a fair way to describe where you are?
Yes, the important things for investors to realize is that market declines start out with complacency as being the most dominant emotion at that time. And the means that most people are half asleep, and they are just not paying attention. They don’t think the markets can go down, so they don’t think there is any need be watchful, but that is exactly when an investor needs to be particularly alert. The last stages of a decline, the very last couple of months of a market decline are the most intense, because that is when the panic sets in, and that is when it is absolutely essential that you are already out of the market. You surely don’t want to go through that final stage.
So, I am trying to pin you down a little more as to where you think we are in this process. It is apparent that you are concerned and you are cautious and that you think the technicals and the market internals are implying that — I don’t want to say that we are in the ninth inning — but is it safe to say that we are late in the cyclical bull market within a broader secular bear market, or do you not make that distinction?
I don’t make that distinction. I think that those terms tend to block an investor from really clearly seeing what is going on.
I prefer to just concentrate on the idea that about every four years on average we have a setback in the market that typically last for anywhere from nine to 11 months, and prices typically drop in excess of 20% on average. I think that is the major thing to concentrate on. Investors simply have to go back through history and realize there is a very consistent pattern of market bottoms about every four years. You can go back and see, for example, there was a major bottom in ’49, ’53, ’57, ’62, ’66, ’70, ’74, ’78, ’82, ’87…
’87 missed by a year, but…
What a miss. Then ’90, ’94, ’98, 2002 and that would lead us four years later to another major bottom in 2006. And I think the consistency of that over many, many, many years simply says that there is a cycle to the stock market, much like the cycle of weather. Every year has a summer and a winter to it. And we are used to that and we adjust to it. At the same time, the stock market has a cycle to it that is about very four years and investors need to realize that that cycle exists and to accept it and adapt to it.
People seem to have a hard time looking at cycles that are longer than they are used to. The day and night cycle … the full moon, even the seasons are the type of cyclicality that humans very easily conceptualize. But thinking about four years, unless you are talking about presidential elections or Olympics, people don’t really think that sort of cycle applies to the stock market.
Well, that is where the old saying comes from: Those who fail to learn from history are doomed to repeat it.
Paul, that is the ultimate point to stop on. Thank you very much for your time.
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Barry Ritholtz
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