What Technical Indicators to Look For In a Market Top

March 23, 2015 • Education • Tags: , ,

This article was written by Patrick Brik

Forecasters are continuously making market predictions with regard to performance and target levels. The purpose of this article is not to call a market top, but rather focus solely on the indicators to keep in mind when trying to decipher whether markets have topped.

Trend

As the trend matures it needs to be tested to make sure there are no underlying divergences that may question validity. When broad market indices are making new highs, it’s good to see selected subsectors also making new highs. This confirms the trend because healthy trends have broad based participation. In the chart below we isolate the market top in 2008

03-07 trend

The S&P 500 continued to trend higher with higher highs and higher lows. The problem, though, was that many cyclical sub sectors had long begun to weaken before the S&P500 made its top. This is an unconfirmed trend. The S&P 500’s topping pattern was developing as the subsectors were underperforming the broad index.

The current rally from March 2009 to the Present is shown below.

09-15 trend

The current rally is exhibiting a clear example of the strength of trend.  Broad market index S&P500 is making new highs and these are confirmed by the underlying sectors.  There should be no topping pattern evident.  The current state of trend has yet to signal any divergences that would question the validity of the trend. The trend is strong and we can only conclude that prices will continue to climb.

Momentum

Momentum indicators help to confirm the validity of a trend and are widely used by traders. At the prelude to a top, momentum indicators will begin to wane.  Slower momentum is a result of smart money distributing shares to late market entrants.

The monthly RSI and MACD will be used as the momentum indicators to eliminate random noise that may develop in these indicators. The rally from July 2002 – October 2007 is shown below.

03-07 momentum

Monthly MACD had crossed and the histogram turned positive in April of 2004, signaling bullish momentum. These remained this way until November /December of 2007, where MACD reversed to a bearish stance.  RSI further confirmed bearish momentum when it crossed below 50 in February 2008, and failed to break above RSI 50 in May 2008.

If we compare these indicators to the current rally from March 2009

09-15 momentum

Momentum indicators have yet to give a clear signal. MACD can turn negative in the months ahead, but that is speculation.  RSI is overbought at its current level, but it can remain so. RSI is still above 50 and I have yet to see anything other than being overbought that would cause any concern at this moment in time.

Volatility

Markets prefer low volatility, so the focus is on when we are to expect an increase in volatility. From 2003 – 2008 shown below.

03-07 VIX

From the earnest of the rally in 2003 the VIX index had continued to make new lows as the $S&P500 made new highs, thus confirming the trend.  An apparent divergence emerged in 2007 as the VIX began to change trend and make higher highs.  The $S&P500 continued to make new highs, but the relationship with the VIX had changed. The new highs were not confirmed with new lows in the VIX.

The current rally is shown below.

09-15 VIX

We see the same relationship that we saw in the previous rally.  New highs in the $S&P500 are confirmed with new lows in the $VIX. Volatility has increase in recent months as the VIX has spent most 2013 and 2014 below 22, and has since traded above 22 on 4 occasions. There is also a divergence emerging and volatility has increased. With VIX at 13 though, it is only worth noting that this may be the start of something.

Conclusion

Trend is mature, but no signs of abating.  Momentum is positive, but is converging and a bearish signal can develop in the near future, but has not of yet.  Volatility has increased but there has yet to be that defining moment. The markets will continue to move higher until a top develops, which take time.  Watch for these discussed signals to eye the market top.

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