How do we know if we are close to a market top? This week’s newsletter is the first in a 2 part series focusing on identifying a market top. This week, we will look at some of the technical analysis tools in our tool box, along with the Investor’s Business Daily (IBD) methodology, for identifying market tops. Next week, we will focus on pattern analysis of a market top.

Much like a market bottom, a market top is easy to see in hindsight. Our ability to anticipate a target/potential market top can keep us in the market during short term volatility AND get us out of the market at/near significant tops. There are some characteristics of price action that always occur at market tops. We’ll get into those characteristics and how to apply them. In the end, we can only confirm a market top in the rearview mirror…

It was a positive week for the TSP with all funds in the Green! For the week the C fund was up 1.16%, S fund up 2.49%, I fund up 1.00%, and F fund up 0.18%. While it was a green week for the TSP, the underlying price action did not inspire confidence. We did not see explosive price moves off of support at the 50DMA like we have seen at prior tests of the 50DMA.

Analysis to Anticipate a Market Top

In the 6 month daily chart of the C fund we see support at the 50DMA 5 times in the past 6 months. After the February test, price gapped up and moved higher for 2 weeks. After the first March test, price moved higher for almost 2 weeks without a single down day. After the late March test, price exploded higher thru mid-April.

We had 2 tests of the 50DMA in May. After the first test, price rolled over at the 10DMA but found support again at the 50DMA. Since the test on 19 May, price has moved higher and reclaimed the 10DMA BUT on very low positive volume. Every up day in May has been on much lower volume than the down days. (Thursday’s big volume up day was a fake that I will explain below). Price is hitting significant resistance between 4150 and 4200. Volume is secondary to price but, it is important. When volume is higher on down days than up days, it means that there are more sellers in the market than buyers. This does not guarantee a market top but, it is a serious concern.

In the intra-day chart of the C fund below, we can see the big spike in negative volume on Thursday at the close. This accounted for the majority of the daily trading volume. Because price finished higher for the day, it appeared to be a big volume up day for the market. In actuality, most of the volume was negative within the trading day.

Investors Business Daily (IBD) newspaper has a Market Pulse pictogram in its Big Picture column each day. This pictogram tells us when the market is in a “Confirmed Up Trend”, “Market Under Pressure”, or “Market in Correction”. It also gives the number of Distribution days on both the Nasdaq and the S&P500 over the past several weeks. A distribution day is defined as a price loss of at least 0.20% on volume higher than the day before. 4 to 5 distribution days over a couple of weeks is a clear cause for concern. Again, it does not guarantee a market top but, virtually all market tops show distribution days before price falls significantly. Below is the Market Pulse from Thursday…

Another tool that we can use to anticipate a market top is Fibonacci Extensions. The chart below shows that the S&P500 (C fund) hit the most common extension, 161.8%, in mid-April. Since then, price has gone essentially sideways. Market tops often, but not always, happen at 161.8% extensions.

Anticipating a market top is tricky. It is certainly not the same as identifying a market top, which happens in hindsight. Taking everything into consideration including weak price movement following support at the 50DMA, multiple distribution days over the past few weeks, and several weeks of resistance at the 161.8% Fibonacci extension level, the risk of being in the stock funds right now is very high. To be clear, I AM NOT calling this a market top! I’m saying that downside risk outweighs potential upside gains right now.

What would get me back into the market? A big follow thru day, ideally 2% or more gain in price, on volume higher than the previous day. That would indicate institutional buying (the opposite of a distribution day). Fortunately, the next time the market opens, it will be a new month and we will have 2 new IFTs available…

The Daily Charts

We’ve covered the C fund above so, let’s dive into the other TSP fund charts…

The S fund had a decent week in terms of price but, we are not seeing the kinds of explosive price moves that have been typical. Compare the daily price moves from December thru mid-February with the price moves since mid-May. We are not seeing explosive moves higher that would indicate a new rally attempt. This kind of tepid price action is consistent with consolidation that we’ve seen over the past several months. We need to see explosive moves higher and a close above 2250 before getting back into the S fund.

The I fund chart is in good shape. It is clearly in a long term up trend. Friday’s reversal day at the upper channel line would indicate that the next short term direction is down. Every time the I fund hit the upper channel line in the past 6 months, it has rolled over and found support at its 50DMA. IF we get a solid close above this channel line, that would be very bullish…

The F fund looks like it wants to break higher. After a huge sell off, the F fund hit a bottom in mid-March. It then rallied thru mid-April, corrected, and closed just barely above the April high early last week. A daily close above 114.75 would be very bullish for the F fund.

Bottom Line

Market risk is high and we are still early in the volatile summer months. Given all of the technical factors described above, the risk/reward ratio is not in my favor. I’m happy to remain in the G fund until conditions improve.

I hope you all have a safe and happy Memorial Day! Please raise a glass to those no longer with us.

Jerry