Against the Grain

"Going against the grain may result in a few splinters, and it may rub a few people the wrong way, but going with it is like forcing your true self to walk the plank!" - David Roppo

I just love this quote as I have always forged a path that is anything but conventional and certainly a lot of money is made by catching a market top or timing the turn at the bottom.  This is not for the faint of heart though as many an investor has ruined themselves by betting against the freight train that is a run away market.  The reason people continue to try is that the rewards are so appetizing and the ego that comes with it is enormous.

On the ego side I am sure you have been to the party where one person has a crowd around them and is expounding how they timed the market to perfection, caught the swing and made a fortune.  That is ego talking as we all know that the only way to catch these events is through sheer luck.  But that said there are a number of indicators that people use to try to gauge whether we are getting close to a top or at least whether the market is running out of control and these are called contra indicators.

One theory goes that any market that runs a long way either up or down is prone to correct itself back to its long run trend line.  When the market hurtles above the trend line during an extended bull market the theory expostulates that it is akin to an elastic band being stretched away from the line and that eventually it will snap back.  However it often does not snap back exactly to the line but bypasses it falling further than it probably should until it turns and rockets back.  So looking at how far the market is from this trend line is one indicator that the market is ripe for a correction.

Another indicator that can show overheating is the IPO market.  Last year was a record for Initial Public Offerings (IPOs) of companies that had no earnings.  An IPO is the procedure used to become listed on the stock exchange.  A company essentially broadcasts that they are going to go public and tries to entice investors to buy their shares.  The company and often times the management team pockets this money and the investor hopes that the price paid for the stock appreciates.  In normal times companies will only attract investor interest if they are solid companies with stellar earnings prospects.  During heady times investors pile into companies that have no earnings on the hope that earnings will magically appear out of thin air because the company now has billions of dollars.  This shows a very frothy market and can be used to show that a market is near a top.

Another indicator used is the level of investors that are bullish versus bearish.  When investor sentiment reaches a climax of around 85% all agreeing to the direction of the market it should be time for you to think the other way.  A healthy market has a balance (not necessarily 50:50) of bulls and bears.  In this environment good companies are rewarded and poor ones are punished.  When sentiment gets skewed even the poor companies see their stock prices rise and good companies see their stock price sent into orbit.  This results in the pass the hot coal syndrome where each investor buys on the hope that there is another one ready to purchase that same position from them at a higher price.  There is no fundamental value placed on the investment just blind belief in the continued momentum.  Once the momentum breaks everyone heads for the exits and carnage ensues.

Now these are just three but there are plenty more that I could expound on but the point to the blog is that while no single indicator will show you a top as more and more of these contra indicators pop up the odds of a continued rally or a continued correction start to shift to a change in direction.  The issue is when does the direction change and there is no magic bullet to answer that question but one thing that you can be assured of that when things turn they normally turn quickly and with a vengeance and this is why you can make so much money catching the turn.  That said though with all the Federal Reserve money being pumped into the system and with interest rates low there is no saying how far this market could go so betting on a change in direction could cost you a pretty price and most of us do not have the deep pockets to fight the tape.

One thing that you may have gathered from this blog is that there were plenty of times where the word HOPE was used.  In investing HOPE is the worst four letter word in the dictionary and so if your investments are based on the HOPE that things will continue this might be the best contra indicator of all that you should review your strategy and save face while you still have time.