Classic Signs Market Top Setting in? Why We Think So

by Michael Lombardi, CFP, MBA

In spite of widespread layoffs across the U.S. and the continued depressed real estate market, optimism is an easy commodity to find these days. The stock market has been rising and investors, economists and analysts are feeling more optimistic than they have been in months. From my past experience, where optimism reigns, trouble follows. reports this morning that stock investor optimism is near a two-year high. In a survey, most investors believe that the stock market will be higher in six months’ time than it is today. This is optimism.

Also disturbing is the fact that short selling on the NYSE is on a decline. The number of shares short on the NYSE is at a two-to-three-month low. This means that even the short sellers (those who believe that stock prices will fall) are pulling back their bets.

If I’ve learned one thing about the stock market (in a career that is approaching 30 years), it is that the market always does the opposite of what is expected of it. No one expected the Dow Jones Industrial Average to fall to 6,440.08 on March 9, 2009, but it did. Look back at news stories and analyst reports of that month and few, if any, predicted that stocks would be 44% higher five months later like they are today.

While I will not pretend to be a stock market expert, all I can offer is my interpretation of the studies of the market I undertake. When I look back at bull markets that have gone bust, once a bear market sets in, there is usually a rally (often referred to as a retracement) of 30% to 50% of the market’s first down leg.

Hence, with the Dow Jones Industrial Average falling from its high of 14,164 in October 2007 to 6,440 in March 2009, it lost 7,724 points. If the market was to regain 50% of that loss, the Dow Jones would be sitting at just over 10,000 today — something we are getting very close to. I have written about this opinion many times today and want to reiterate today for the many new readers who have been signing up for PROFT CONFIDENTIAL in the past couple of weeks.

The fact that optimism is setting back in with investors and that short selling is on the decline are signals, at least to me; classic signs that we are getting close to a market top in this stock rally in the confines of a general bear market.

Where the Market Stands:

The Dow Jones Industrial Average sits about 5.3% higher today than when 2009 started. Does this current rally have steam left? I believe so. But we are getting close to a top and I want my readers to be prepared for that top. Volume has been very low on this advance, which is of concern. I remain in the small group that believes that once this rally tops, a testing of the March 2009 lows would be in order.

What He Said:

“As a reader, you’re aware I’m not a Greenspan fan. In the years that lie ahead, I believe we (and our children) may pay dearly for the debt bubble Greenspan created during his tenure as head of the U.S. Federal Reserve.” Michael Lombardi in PROFIT CONFIDENTIAL, March 20, 2006. “A low savings rate was eventually blamed for the length of the Great Depression. Consumers just didn’t have enough money to spend their way out of the Depression. With today’s savings rate being so low, a recession could have a profoundly negative effect on over-extended consumers.” Michael Lombardi in PROFIT CONFIDENTIAL, March 26, 2006. Michael started talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.