The Art and Science of Predicting Market Turns

A staple of stock market journalism is predicting market tops and bottoms. It is understandable why there is so much focus on predicting market turns, but the problem is that no one can do it consistently with a high degree of precision.

Proclamations that the market is about to form a significant top attracts attention and provide a sense of control and predictability, which is why it is so common. Inevitably, the argument about why the market is about to fall apart is very astute and logical. It will contain compelling arguments, but the problem is that the market doesn’t care very much about human logic, especially in the short term.

A significant factor when the market is making new highs is known as "animal spirits." That term reflects the fact that the action is driven by emotions and factors that have nothing to do with valuations, economics, or other quantifiable factors.

Despite the futility of trying to call market tops, we can expect more and more of those predictions as the market rises. Invariable, the serial top callers will eventually be right. They will declare victory when there is a pullback of 2% and hope that people forget that they are still sitting on substantial losses from their initial predictions. The great secret of being a market guru is hoping that no one remembers your entry points.

So how do we deal with a market that is becoming extended and faces a growing danger of a reversal due to overbought technical conditions?

The first step is to be very clear about what you are trading. If you are trading individual stocks, they are likely to be only loosely correlated with the major indexes. Just because the S&P 500 or the Nasdaq 100  (QQQ)  is overbought doesn’t mean that the individual stock you own is equally suspect.

Stay focused on the price action of the stock you actually own and don’t trade them based on the technical conditions of the indexes. In nearly all markets, many stocks exhibit very strong technical patterns, despite the indices appearing weak. Selling an individual stock because some expert guru thinks the indices are going to crash is almost always a mistake. As Peter Lynch famously stated: “Far more money has been lost by investors trying to anticipate corrections than lost in the corrections themselves.”

The best way to predict a market turn is to focus on trading the individual stocks you own. When the market starts to weaken, your money management should prompt you to exit positions. You should be selling names that are breaking support levels. That will increase your cash levels, and if the overall market is struggling, then it will be tough to find good charts to buy. The combination of stop-outs and a paucity of good charts to buy will force you to the sidelines while a market correction takes place.

There is no need to evaluate the indexes and try to determine the exact moment they are hitting a top. Let your individual stock holdings make that decision for you. Technical analysis of indexes only applies to indexes.

If you are trading the indexes or playing the game of timing a turn, then the main thing to look for is intraday reversals and weak closes. When an index fails intraday and closes weak, that is a warning sign that there is some shift in sentiment. It may not be anything significant, but if there is follow-through to the downside on subsequent days, then increased caution is warranted.

When I start to see some weakness in indexes, I don’t rush to sell my stocks that are still technically strong, but I may tighten up my stops and reduce some larger positions. Weakness in the indexes is a warning sign to be more vigilant and prepare to act quickly if conditions continue to deteriorate.

The main thing to understand about market timing is that the emotions that drive the market can’t be predicted with precision. Logic won’t work, so you have to focus on price action rather than arguments about valuations and economics.

At the time of publication, DePorre had no position in any security mentioned.