How to Spot a Market Top

 | Feb 22, 2013 | 8:18 AM EST
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Intelligence is the ability to adapt to change. --Stephen Hawking

After the poor action Wednesday, I moved my market view to "topping process" from "uptrend." The follow-through to the downside Thursday confirmed that bias. There hasn't been enough weakness to declare a full-fledged downtrend, but there is sufficient negative price action to believe that a top is beginning to form and further upside is limited.

The key thing to remember about market tops is that there are likely to be bounces and spikes as they form. A top is a process that plays out slowly as sentiment shifts and the mood begins to change. Early in the topping process there is likely to be aggressive dip buying as the folks who wanted to buy weakness during the uptrend finally have their chance. After they shake off the jitters caused by the first real selling in a while, they usually produce a good bounce or two. The ultimate failure of the bounces eventually results in a top.

Typically, after a couple of distribution days like we have just had, some sort of oversold bounce will produce a sigh of relief among the bulls. The pullback will be shrugged off as a momentary glitch and there will be a rush to reload long exposure as the action runs back up. This is the "suck in" phase of the topping process marked by the bulls saying there really was nothing to worry about.

We need to watch for whether the strength is used to unload positions by those who grew nervous after two days of selling or whether it's driving new buyers afraid to miss out as we recover and trend higher.

After the recent selling, my view is that strength is likely to be sold in the next few days as the topping process plays out further. I don't want to be overly negative but I will be less trusting of strength.

This market has often made fools of anyone who underestimates its ability to bounce back from weakness. I've written about the propensity for V-shaped bounces many times and it would be foolish to think we wouldn't see it happen again. The computers that so often drive this market have a strong tendency to keep bounces going. The bears have been burned many times trying to estimate when they will end.

There's positive action to start the day as Fed Governor James Bullard offered up dovishness on CNCBC and Hewett-Packard (HPQ) puts up OK numbers. We have to watch for failed bounces, but give the bulls a little bit of room first.

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