There are many examples of market blow-offs and subsequent crashes. It is a very difficult balancing act trying to decide whether to get out during the parabolic move, and possibly leaving huge gains on the table, or to hold on with the risk of overstaying the market and giving back much or all of the gains. There is no easy answer. However, many lessons can be learned from observing past large market moves and the inevitable crashes that followed. Gold in 1980 was a good case study, as was the Nasdaq blow-off in 2000. Many individual stocks make great studies as well, including many recently. This article may seem similar to the one on trend change. But my aim here is to try to suggest some clues to help find an exit point during the exceptional, large impulse move.
Is there a common characteristic that can warn of danger in a timely way? Does a bell ring at the top to suggest we stop acting like pigs and should take our profits? No, there isn’t one bell that rings at the top, but there are many little warnings.
Sentiment indicators do try to give a warning when everyone seems to be on the same side of the trade. If almost all traders have the same opinion, and are all positioned on the same side of the market, who is left to buy or sell? This is obvious, but how do we measure it. Traders who agree on the current price, but disagree on value will characterize a healthy market that has room to move. But if everyone agrees on both price and value, the market is sure to go the other way.
Most futures markets and stock indexes have many sentiment indicators that give an estimate of bullish or bearish bias. In addition, futures traders have the Commitment of Traders weekly report that separates the large traders, small traders, and commercial interests. The problem with these approaches is they are terrible for making timing decisions. Markets can stay overbought or oversold for months on end. Even extreme readings don’t help when the market is in a sustained trend. And, I believe the market character has changed in recent years, and the sentiment indicators are becoming less and less useful. Everybody knows about them. What everybody already knows won’t help much.
However, I still find one sentiment indicator that works almost perfectly. When a market has had an extended, directional move and if a market pundit is asked if the trend perhaps has gone a bit too far, and the answer is “This time it’s different.” That’s the sell signal. It is never different. It always looks different at the top because all the fundamentals that caused the previous price advance are now known and reported by the media, and already in the price. What had caused prices to advance is now being learned, and now everything looks so bullish that it seems obvious that price has to now go up. But it already has gone up. It’s now too late. The bus has not only left the station; it has already arrived at its destination.
I’m a visual person; therefore I view the ups and downs in the market visually, like a vehicle going up or down a hill. Imagine a bus going along a flat road with few passengers. Someone can easily get on the bus at each stop. This goes on for a few miles. The bus starts to climb a gradual hill, while more people get on at each stop. All of a sudden most of the seats are full. The hill the bus is climbing starts to get a bit steeper. It is a hot summer day. More and more passengers get in at each stop. Now it is standing room only, and the bus is climbing a very steep hill. It is struggling, trying to make it up the hill. A little bit of steam starts to come out of the engine compartment, but nobody notices. At each stop people keep climbing aboard. The passengers are oblivious to the straining of the bus. They are talking or reading. They just want to get to their destination. Now the bus is overcrowded and overheating. People are hanging out the windows and holding onto the outside of the bus. It keeps trying to get up the hill, barely moving at this point. One of the passengers asks a neighboring passenger if he thinks the bus will make it, citing an example of a previous bus trip where the bus broke down. The neighboring passenger replies “this time it’s different, the bus was fixed since that trip.” Right at that moment there is a big clunking sound with steam coming out of the engine. The ride is over. All the passengers get out in the worse possible location. Of course, the next day the bus is fixed and the whole process starts over.
So, back to markets and price charts and away from buses. There are some clues from the price charts, that in my opinion, are more direct and timely than watching sentiment. Divergences between prices making a new high, which are accompanied by lower oscillator readings, are an early warning. The problem is that there can be many divergences in a series before the market finally pays attention and turns around. In my experience, there will be a series of small divergences, and then one last push to a high accompanied by a larger divergence.
The above chart is the Nasdaq Composite Index going into the last upthrust to the market top in 2000. The trend channel on the price bars is the regression curve with standard error bands. The oscillator on the lower subgraph is the double stochastic. (See right sidebar for links to articles on these indicators) You can see a number of divergences between the advancing price structure and the double stochastic. The last divergence, marked by the red lines, showed a good break, but the market tried to rebound to retest the high one last time, just to make sure. The market finally broke the regression curve, marked by the red down arrow, and quickly broke the previous swing point marked by the yellow line. Also notice the length of the impulse moves up, marked by the two thick blue regression lines. The first impulse up is quite long, and the next impulse up is a bit shorter. There was really no third impulse up. So much for the Elliot wave people waiting for the five-wave structure.
The above chart shows the S&P 500 cash going into the big crash of 1987. Here the two impulses up are of about equal length, with the second impulse a bit steeper in angle. After the first impulse, and the break of the regression curve, the market rallied back up several times to test the curve, and finally succeeded and created another leg up. The next time it broke the regression curve the tests finally failed. The red down arrow is drawn on the same bar as the failure of the adaptive CCI to penetrate the zero line and the resulting downward momentum. There were several days of warning prior to the big collapse. Many other momentum indicators would have also warned of problems, however the adaptive CCI did not give premature buy signals prior to the collapse.
Here is a chart of Titanium Metals from last year. Here is a case of a parabolic move up on increasing volume. The CCI did a good job of finding a divergence, which would have been a good warning to tighten up stops. The red dots below and above price is the Welles Wilder parabolic stop, which is included with most software charting packages. It does a good job of getting you out in these parabolic moves. It is named appropriately. Be warned that in a sideways market this indicator will chop you to pieces. But when you see an accelerating, parabolic move, such as the one in this chart, and all the commentators say “this time it’s different,” this is a good indicator to use to keep you from getting emotionally sucked into the euphoria.
Here is another high flyer from not too long ago. You can see that it looked like a parabolic move was starting, and then a sudden break occurred. Then the stock tried a second time to mount an impulse up. It started to succeed, but then faltered. The divergence between the new price high and the lower adaptive CCI was a good warning to tighten stops. An even better warning was the declining volume pattern, marked by the red line on the bottom subgraph. The blue dots in the example are also from Welles Wilder, but this time they are the volatility stop. It gives a good place to exit as a last resort if none of the other clues got you out. This is similar to the parabolic stop, however it takes in volatility, and can therefore expand and contract based on the range of the bars. They are both explained in his book (see book section on this blog) and probably many other places on the internet.
The above chart shows a huge move made recently by Dryships. The impulses up, marked by the thick blue lines, show a long first impulse, followed by a shorter but steeper second impulse. The whole pattern looks like a parabolic blow-off move. Judging from the acceleration of the linear regression curve, the upmove may not be over. However, the penetration of the parabolic stop (the red dots) makes it obvious that one should exit and stand aside. Also, prior to the parabolic stop being hit there was a series of divergences between price highs and the declining double stochastic in the bottom subgraph. If another leg up occurs, one can always get back in. However, after a parabolic move such as this one, it is prudent to lock in profits when these warning signs appear. Let another trader try for the last few dollars of the move.
All the large, exceptional moves are unique. Each one will unfold in a different way. And, each one will give clues as to their termination point in a different way. But if you study enough of these moves, and subsequent collapses, you will begin to build a set of conditions to watch for to at least be on the lookout for an exit point, or at least a reason to pull up a tight stop. It always looks the most bullish at the top. You need some guidelines to help keep the euphoria in check.
There is no perfect rule for timing these events. Most of the time I get out too early, and if not I usually got out too late. It is easier to get out on strength, when the commentators on CNBC are jumping up and down with joy that the market, or stock, will never stop climbing because “this time it’s different.” It’s far better to get out when everyone wants to buy, than when everyone is looking to sell. It is difficult psychologically to then watch the market climb ever higher without you being on board. It is even more difficult overstaying the trend and giving back much of what you had on paper.