Update: So far, two of the three technical warning signs for a possible peak in the market have been raised. The most recent came in June as the market’s internal momentum failed to confirm the S&P 500’s new record highs, as evidenced by a long-term MACD sell signal. If past is prologue, the market will likely attempt to get back above its 12-month moving average in the weeks and months ahead, which, if it fails to do so, will heighten the risk of further declines.
It is said that an image is worth a thousand words. This chart presents a possible roadmap for monitoring the risk of a major peak and bear market by comparing the technical similarities between the prior two market tops and where we are today. I go into each of the three technical warnings signs in more detail below (click image to enlarge).
Red Flag Number One (√)
The first technical warning sign raised earlier this year was indicated in the chart above by a significant divergence between the relative strength index (RSI) and the market itself. This is noted by a declining pattern of lower highs in the RSI as stocks continue to make higher highs, a sign that the market is “topping out”. In the late ‘90s this divergence persisted for many years as the tech bubble reached ever-higher valuation levels. In 2007 this divergence lasted over a much shorter period (6 months) before the market finally peaked and succumbed to massive selling.
Red Flag Number Two (√)
The second technical warning sign came in June by a major crossover in the MACD (moving average convergence-divergence) indicator shown in the bottom panel. This is often used by technical analysts as a buy and sell signal. As shown by the dotted lines, a MACD sell signal occurred near both prior market tops in May of 2000 and December of 2007. Given the recent double-digit correction in August, the June sell signal proved to be quite timely in warning of downside risk.
Important note: though I have smoothed this indicator to eliminate any prior buy and sell signals that didn't correspond to major market turning points, as you'll often hear, "past performance does not guarantee future results." Since we must be alert to the possibility of a false sell signal at the current time, we look to an additional red flag for further confirmation.
Red Flag Number Three
When a major line of support becomes resistance, this often warns of a change in trend. This occurred around January-February of 2001 and May-June of 2008 (see red circled regions on the chart) when the S&P 500 failed to break above its 12-month moving average. After that point in time, the market persisted in a bearish downtrend until a confirmed change of direction with a new bull market. Currently, the S&P 500 has broken below its 12-month moving average and will likely attempt to get back above in the weeks and months ahead (sentiment and historical patterns put odds at later this year or early 2016 - see here). If the market fails to do so, our third red flag will be raised, which heightens the risk of an extended decline.
As we all know, history does not repeat itself, but it does rhyme. Even if the same technical pattern plays out again (i.e., all three red flags come to fruition), no one can predict the exact magnitude (depth) or duration (length) of a subsequent market decline, should one occur, since no two tops or bear markets are exactly alike. The most prudent investment strategy is to monitor market action, incoming data, and make corresponding adjustments as the situation requires. The chart and analysis presented above is one of many tools for doing just that. For additional reading, I highly recommend Chris Puplava’s recent big picture outlook on the market and global economy, which you can access by clicking here.