Spotting Market Turning Points
Contents
Volume
Volume can be an important indicator in spotting market turning points. A trend should be supported by sustained and healthy levels of volume. If volume begins to fade, this may be a sign that the trend is weakening. The market is exhausting the buying or selling pressure that is supporting the current trend. There are also instances of "blow off peaks" (or troughs) in which the mania or fear in the market reaches a feverish intensity and all the buying or selling pressure feeds back on itself and is exhausted in a very short period. This is more common in bubble (or crash) situations where volume increases with the continuation of the trend rather than normal market action.
Oscillator divergeance
Oscillators are considered leading indicators. Generally, they will turn before the price action does. When the price of a security or asset continues to set new lows, but oscillators have begun to trend upwards, this may be a sign that a bottom is forming or the downtrend is weakening. Conventional trendline analysis and moving averages may also be used on oscillators to spot potential turning points before the price action turns.
Overbought / Oversold Conditions
Some technical indicators may be used to determine if a security is overbought or oversold. An overbought or oversold condition will not tell you much by itself, as trends may continue with overbought or oversold conditions for quite some time, but it can serve as a warning sign. Securities often reach extremes before they begin to turn, correct, or consolidate. Overbought and oversold conditions can serve as a warning. They indicate that additional attention may be warranted to determine if a correction, consolidation, or break in trend is near.
Period
It is important to note that the time period on your chart should be in proportion the trends you are examining. A daily chart may be useful when looking at a 1 to 6 month trend, but will prove less useful for a 3 year trend. For 1 to 3 years, weekly charts may be more appropriate and monthly for even longer term trends. It should also be noted that the longer the trend, the more powerful it typically is. A 1 year trend should take precedent in your analysis over a 1 month trend.
Leading Indicators
When examining broad market indices, such as the S&P 500, certain indices and subindices are used as leading indicators. New highs or lows in the broad market should be confirmed by new highs or lows in these leading indicators. If they are not, the broad market may be nearing a reversal. Many of these indicators are made up of high beta and aggressive stocks. The most commonly used are the Dow Transports, US small cap indices, and the NASDAQ. Cyclicals and, under more normal circumstances, financials may also be used.
Comparison and Cross Market Analysis
When investors and asset managers become worried that stocks may turn downward, they tend to abandon high beta stocks for safer low beta stocks. This means the traditionally "safe" sectors of utilities, telecom, and consumer staples should begin to outperform more aggressive sectors like industrials, materials, and technology. There may also be a shift from stocks in general, to safe haven assets such as treasuries and precious metals. The reverse is true for spotting market bottoms. There will be a shift from safe haven and conservative investments to high beta, aggressive assets.
Valuation
When stock valuations are high, it is usually the result of high expections for earnings growth. The converse is true of low stock valuations. Often times these expections, whether high or low, outpace reality. When valuations become exceedingly high or low, a reversal may be near. It is important to note that this valuation based approach is much safer with long term, broad market trends rather than individual stocks. As Keynes says, "The market can remain irrational longer than you can remain solvent."
When looking for a top in an individual stock, the high flyers are usually a good place to start. These companies are usually publicly visible. They provide products or services that the average person will use or encounter in their every day life and are often times considered innovative or different from their competition. They also tend to have high growth expectations and get a lot of media attention. All this public attention and enthusiasm should be coupled with impressive stock price appreciation. While earnings growth may occur, even at high levels, a dramtic increase in P/E ratios should be seen as the stock price continues to climb. When all these things occur, it is usually a good indication that the stock price and growth expectations have become disconnected from reality. However, there is no way to tell when the eventual top will occur.
Looking for bottoms in a stock based on valuations can be risky. Investors must be very careful not to end up in proverbial "value trap." P/E ratio compression should be occurring while earnings are increasing. Usually this happens in two kinds of stocks: those which are lesser known, and those which have had negative headline coverage. In the first case, the stock may be a quality company who is simply trending down because it is following the index. In the second, negative expections may have outpaced reality. In either case, it is extremely important to research the company and make sure the low valuations are not justified before purchasing.
The above techniques may also be applied to the broad market, however chances to do so occur infrequently. The tech bubble is a good example of a time when the public opinion of the future of business and the economy caused broad market stock prices to become disconnected from reality. P/E ratios expanded dramatically and ultimately led to a bubble which subsequently reversed.
