How to gauge stock market tops

Vikas SinghaniaTrade Smart OnlineAmerican comedian Joey Adams says the difference between playing the stock market and the horses is one of the horses must win. In markets, if a crash comes it takes everyone with it. The truth behind these lines is that when the market falls it takes everyone who is invested (or in the race) with it. There has been more money lost in hope than opportunities lost in fear of missing out. Novice investor tries to go overboard with his investment in a bull market and hopes that the stock will move higher or he can extract a few more rupees in the rally. If the stock fails to touch his price level he holds on to it in hope that the price will be hit. He then keeps on waiting but now his hope of touching the previous top is replaced by price touching his entry level. But when he is fearful, he merely misses out on the opportunity but at least he still has his shirt on.Most successful businessmen and investors have the ability to call the cycle right. For them fighting for the last rupee for a good entry or a good exit is not important. What is more important in when they are in the investment and when they are out of it? Surviving the bad time is all that it takes for them to be a winner.In order to survive the bad times one needs to know when the good times are ending. In market parlance, it would mean when the bull market is nearing its run and a bear market is starting or when a market top is near. It is humanly impossible to predict a market top or a bottom. But sensing a market top is good enough to prosper in the market.Even in the current market scenario every correction is viewed by investors as the end of the rally. Thus we see sharp sell-offs at corrections only to find the investors coming back in the game after the correction. The fear of being trapped in the market is preventing them from staying invested. As mentioned earlier, one needs to call the cycle right and strategize accordingly.There are various ways in which a market top can be identified. Tools may differ, but almost all of them call a market top very close to each other. We shall look at some of the tools which can be used even by a retail investor to see if the market is near the top. Depending on the comfort levels one can chose any of the methods – Fundamentals, Technical or Sentimental.Fundamentals: The most common and effective tool in the fundamental space is the price to earnings (PE) ratio, commonly known as PE ratio. Indian markets have historically traded between a PE of 12 and 18 for S&P BSE Sensex while NSE Nifty gyrated between 14 to 22. Two of the previous bubbles where burst in the vicinity of PE’s touching 25 (for Sensex), while the biggest bubble of 1991 was when the Sensex traded at a PE of around 42. NSE 50 stocks Nifty presently trades around the 23.7 level, while the 30 stocks S&P BSE Sensex is currently trading at 20.7. All one needs to do is to see where the market is with respect to the previous peak to gauge if we are in bubble territory. Similar tool can be used to gauge where we stand in terms of individual stocks. Stocks have a tendency of touching higher PEs as compared to the broad market, but testing historic valuation and benchmarking against that will help one avoid the euphoria of a bull market bubble. Technical: Technical analysts have more visual tools at their disposal to identify a market top. The best is the use of over a century old Dow Theory. If the low preceding the major previous top is broken then Dow Theorists will term it as the end of the bull market. Similarly an extremely overbought situation on some of the oscillators like RSI (Relative Strength Index), Stochastics among others, or simply a long term moving average crossover is a very simple and good enough indicator to suggest a top has been made. There is little point in waiting for the price to recover a bit, ones the technical parameters suggests a top is made. Sentimental indicators: These are the most obvious but least tracked indicators that suggest a top is made. One of the factors that points out that the market is overheated are when the number of stocks touching new highs is falling despite a new high being made. Similarly if some of the fundamentally top performing sectors are not participating in the rally, it is a red flag event. Number of stocks advancing is lower than those falling consistently as the broad market rallies are also another pointer that the market is topping out. Similarly, smaller companies are approaching the market to raise money from the public through initial public offer is an indication that retail investors are being played in the market. Also, if market stops reacting to positive news, it suggests the positives are in the price and it is time to exit. In his book Reminiscence of a Stock Operator author Edwin LeFevre quoted legendary trader Jesse Livermore saying that ‘One of the most helpful things that anybody can learn is to give up trying to catch the last eighth – or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.’Bottom picking and then averaging your way down is as harmful as hoping to catch the top. Getting the general direction is good enough to earn handsome returns in the market. All you need is an indicator to tell you which way is the broad market headed and to follow the indicator religiously.