The Philosophy of Tops

September 20, 2012

While I am not bearish, I would be cautious about plowing into new positions. And, we saw some of that caution on Friday as sellers showed up in many of the strong momentum stocks.

 -Jeffrey Saut, managing director, Raymond James

"Everyone kept saying 'a top is not in place yet.' They persistently pointed to the 'normally reached' levels of this or that statistic that were not yet there to reinforce their desire to remain bullish. ... Apart from statistical measures of increasing blindness, this unwillingness to acknowledge what they themselves were already feeling revealed a comfortableness, a confidence, a conviction that whatever was happening - short-term survivable dips - would continue ... until 'the top,' like a strip tease artiste of our youth would with decorum appear on stage, bow, and then, accompanied by applause from all the bulls eager to cash in on their excitement, would begin to twirl its statistical tassels in front of everyone.

I've gotten so old I can't remember the names of those ladies at the Old Howard, but I can remember that all you got was a flash of this or that, before they waltzed off. Stock market tops are like that. You know it's there somewhere if you squint hard enough, but you never quite see it, so you keep waiting for more. And then, in the end, as the curtain comes down on the bull market you realize that the one rule about tops is not that they provide this or that signal, but that they come before anyone is ready."

... Justin Mamis

I recalled this quote from historian, author, and stock market guru Justin Mamis last week while contemplating the probabilities of a "top" for the recent stock market rally. Of particular interest is his last sentence, "One rule about tops is not that they provide this or that signal, but that they come before anyone is ready." In the current case very few are ready for a "market top" given the consensus opinion that the recent Dow Wow is the start of another leg to the upside. Our analysis, however, suggests the extreme oversold condition that spawned the rally has evaporated, leaving all of our indicators just about as overbought as they ever get (see chart on page 3). To be sure, the S&P 500 (SPX/1465.77) has gone parabolic over the past few weeks, while the Russell 2000 (RUT/864.70) is challenging all-time highs. An overbought condition can be resolved in one of two ways. First, the SPX can pause and move sideways while the overbought condition is remedied. Second, the SPX can pull back to what had previously been an overhead resistance level, but now becomes a support zone. In the current case that would entail a pullback to 1400 - 1422 for the SPX. Importantly, when the stock market generates an overbought condition of this magnitude it suggests there is more strength coming in the future after the overbought condition is rectified. Indeed, uptrends typically do not end on really high overbought readings from the NYSE McClellan Oscillator. So, while I think we are reaching for a short-term "trading top," I believe that following some kind of pullback the major market indices will go higher.

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