How much further can stocks climb before markets encounter the dreaded ‘blow-off top’?

What's that you ask? Veterans traders who've experienced a blow-off top won't soon forget.

Markets continue driving upward to dizzying heights as investors bet the good times will keep on rolling. Maybe they will, but there’s also the possibility they could instead confront the converse—the “blow-off top.”

What’s that, you ask?

A blow-off top is nothing to shrug off. It’s defined as a rapid ascent followed by a series of slides, partial rebounds, and further drops, leading finally to a precipitous decline in market performance, like what happened in 2007 to 2009 or from 2000 to 2002. Like major storms of any type, they happen periodically—more than a dozen times since the 1950s according to some counts.

Time it right, and you can make a tidy profit. If you’re off, which is just as possible, you could face a big loss. And under the right—or wrong, if you will—conditions, a blow-off top could blow up your portfolio.

“A blow-off top is the final stage of a bullish move in the stock market,” said David Russell, vice president of market intelligence at TradeStation Securities. “It follows a long period of gains, and usually results from naysayers throwing in the towel and going [along for the ride],” pushing prices and volume upward.

“Blow-off tops are often only clear in retrospect, and it’s hard to judge when the big run higher is going to end,” Russell said.

However, a blow-off top is more complicated and extended than the description suggests. The easiest way to start understanding the phenomenon is to look at a picture of one. Below is a graph of the S&P 500, demonstrating large-cap activity, and the Russell 2000 for small- and medium-cap. The period from May 2007 into 2009 was a stomach-churning roller coaster that’s hard to forget for anyone who went through it.

As the graph shows, in a blow-off top, not all parts of the market move at the same time. “In 2007, the Russell 2000 completed a double top,” or a pair of peaks, on June, 4 and July, 13, said financial and tax adviser Steven Jon Kaplan. “The S&P 500 didn’t peak until October 9. From top to bottom the S&P 500 slid 57.7% while the Russell 2000 lost 60.0%.”

The whole event can take many months, from the initial highs and then multiple rounds of drops and rebounds. The subsequent peaks keep dropping in size, while the bottoms get deeper.

The pattern of one part of a market peaking earlier than others repeats in other ways. “For example, with commodities, it is almost always the case that the producers of the commodity reach their peaks ahead of the commodity itself,” Kaplan said. “When the commodity is peaking, the producers make lower highs.” That’s a sign a sector may be ready for a major decline.

Kaplan pointed to the example of gold mining funds peaking in April 2011. The price of gold itself hit a high in September 2011 and the funds saw a peak, but a lower one than in the Spring. “This was an early warning of a price drop, and sure enough the entire commodity sector, including precious metals, collapsed and didn’t bottom until January 20, 2016,” he said.

“Period of euphoria”

In any market, increased investment is what pushes shares higher. Additional money represents additional demand with a relatively fixed available supply of stocks at a given time. In a nod to classic economic theory, share prices respond by going up.

The economic explanation of a blow-off top is a “period of euphoria that causes the last of the bears to become bulls [and is] the process of the market sucking in the last of the sideline cash,” which means any available money not invested, said Robert Phipps, director and portfolio manager of Per Stirling Capital Management.

When the sideline cash is exhausted, there is a sudden reduction in the money people will invest into equities. Demand for high-priced stocks suddenly becomes weak and, as a result, prices drop. The dynamic is one that, to some experts, the markets may be playing out right now. Look at the progress of the S&P 500 and Russell 2000 from October 2017 through March 2018 in the following graph.

Kaplan argued that the markets are showing “exactly the same blow-off behavior”—like people putting more money into the markets and growing share valuations, and small- to medium-caps peaking—that previous such events have shown. For example, the Russell 2000 hit a peak at the end of August 2018 and then a secondary one in December 2019 that was down almost 4% from the previous one.

“Not many people pay attention to that, but that’s how many bear markets start, with the smaller and mid-sized companies,” Kaplan said. “Hardly anybody reports on a story how the Russell 2000 did on a particular day or week or year.”

Watch the bond market for clues

An additional concern is that investors may have largely lost their fear, and are increasingly pouring money without concern into markets, also fueled by low interest rates that push interest in stocks over many other investments.

One indicator is in the bond market, with a narrow difference in the yields offered by junk and investment-grade bonds. Investors see risk as systemically lower and so ask less of a premium for it.

Passive trading, which is a much bigger deal these days, can also exacerbate blow-off top conditions. Managers at many passive funds are restricted in the actions they can take. When money comes in, they may have to invest it rather than holding more cash because valuations seem too high. That pushes up share prices. When markets cool and people begin to take money out, the funds then sell shares to create liquidity, which increases the amount of selling and further depresses prices.

Stocks show the lack of fear, and a rush to greater return, as their moving averages are significantly below the current prices. Values are growing faster than usual and that concerns Phipps. “Right now, the S&P 500 is almost 8% of its 125-day moving average,” Phipps said. Had that been 2% or even 4% of the moving average, “it wouldn’t raise an eyebrow.”

Prices have clearly seen the effect. “Right now, we’re at 18.5 times forward earnings, which is really, really expensive on the S&P 500,” Phipps said. The market breadth has been strong, with most stocks having ridden the surge and suggesting that investors are discriminating little between different stocks.

Still, it’s still extraordinarily difficult to tell when the market is about to have a blow-off top. On one hand, the volume of shares trading hands hasn’t been all that high, which would suggest less of a rush to invest mania gripping the markets. Then again, according to a regular survey by the American Association of Individual Investors, as of Jan. 15, 41.8% of respondents expect the market to be up in the next six months. This historical average is 38%.

Keep in mind, the prospect of a blow-off top cannot be adequately predicted—such is the nature of any phenomenon that can be observed only retroactively. Experts therefore advise investors to work with a financial adviser to consider some hedging actions to limit losses.

But whatever you do, don’t blow it off.

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