Market Extremes: Common Themes and Characteristics

“Markets can remain irrational a lot longer than you and I can remain solvent.”

“I should have drunk more champagne.”
– Both Attributed to John Maynard Keynes

The basketball had just been passed to me on the left wing. The game was tied late in the fourth quarter. It was my senior year at Radford High School and we were playing our arch rival, Blacksburg High School, the team that had ruined our perfect season at the junior varsity level just two short seasons ago.

Guarding me was an all-state football player, which meant that he was a superb athlete with great instincts in any sport. At this particular moment, we were running a set play. My role, once the ball got to me, was to make a decision: shoot if I am open (I was not) or pass to a player cutting toward me from the other side of the lane.

This was our standard set and the guy guarding me had already seen us run this play a half dozen times. In fact, he had almost intercepted my pass the last time we ran it; he was beginning to recognize the pattern of the play.

What happened next was the stuff of legend, a story I will tell my grandkids some day (or at least one I will share with the readers of Van’s newsletter…). I broke the pattern. I faked the pass that I had already made many times that night. Then, with a quick crossover dribble to my left, I zipped past a clearly superior athlete for an easy lay-up.

Pattern recognition had given my opponent an edge earlier in the game. Breaking the pattern turned the table back in my favor for this one play.

The markets play out this same “game” over and over again. The market follows a set pattern with great regularity, one that can be exploited if recognized early enough. And just when market participants get most comfortable, the pattern is broken. Let’s look at how to take advantage of both situations.

A Key Characteristic of Blow-Off Tops

When markets hit extremes, they usually do so for simple reasons. Buyers become overly enthusiastic and price an asset above a sustainable level. There are stages along the way in this process that go something like this:

• Recognition of initial price strength brings in aggressive institutional players.
• More conservative institutions then decide that they can’t miss the move and join in.
• Then retail players jump in “en masse” along with the last of institutions who are forced to have the “hot” asset in their portfolio.
• Finally, the end stage of the buying frenzy is powered by both greed and fear—players adding to profitable positions and the last new comers afraid of missing out on the move.

This pattern of staged entry for groups of buyers gives us reproducible signs of a blow-off top. My favorite indicator of this process is the accelerating rate of rise that we see in this chart that published in this newsletter just days before the 2008 peak in crude oil.

The blue lines under the price bars show a “progressively steeper ascent.” (My technical analysis friends will note that these blue lines are not “true” trend lines since only one of the four offers three points of resistance along its slope.) These lines show the acceleration of the price rise and can be an indicator of buyers coming into the market in clumps.

Two months ago, cotton hit all-time highs and was truly a runaway train! I don’t think I’ve ever been able to draw in five lines of steeper ascent. Price dropped more than 25% in the two weeks that followed and has since climbed to even higher highs.

And now for the kicker: the current equity market is looking like those other blow-off markets. Here’s a couple of charts showing the S&P 500. First, a longer view back to the March 2009 lows.

This gives us a perspective for the longer term trend and we’ve started to accelerate off of the lows set at the end of last August. Let’s take a closer look at this more recent time frame.

The markets really can’t sustain this type of upward movement for long. BUT, we must remember the quote attributed to Keynes—the market can remain “irrational” for a long time. And this is especially true when the massive governmental intervention is still working through the system.

The bottom line comes from our basketball analogy above. Patterns like the acceleration of price slope lines are very good indicators as to what the market is likely to do, and following them can help us locate pullbacks. As I learned in the basketball game, it’s the occasional break of the pattern that can lead to big payoffs.

So how can we play both sides of the trade? Here’s a useful general procedure:

• The higher probability play is to follow the pattern. In this case, play a short after a breakdown below the first or second slope acceleration line from above (depending on how aggressive you’d like to be).
• Then this becomes an “if not A, then B” trade. If it goes your way, fine. If not, you would reverse your position and go long on the breakout to new highs.

This type of strategy can help you play these market reversal points and take advantage of the predominate move (reversion to the mean) while giving you a chance to catch the directional move if the trend continues.

I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…

Great Trading,
D. R.