Rather than sit on the sidelines and make useless predictions about market turns, my style is to react as market conditions start to shift. When the price action begins to weaken, then I want to lock in some gains, cut some losers, and raise my cash levels.
Spotting a shift in market character is not nearly as easy as it sounds. If we move too quickly, we are whipsawed when things bounce back, and if we move too slowly, we can give back some hefty gains.
These are the main things that I'm watching for to indicate that a market top may be developing:
First and foremost, look at the stocks you are holding. The simplest market-timing device we possess is our profit-and-loss statement. If you are losing money, then it is time to do some selling. It doesn't matter what the overall market might be doing. If the stocks you are holding are acting poorly, then you need to make some changes. The inverse holds, as well. If your stocks are doing well while the indexes are acting poorly, then stay with what is working and don't let the big picture influence you too much.
Second is correlated selling. In bad markets, stocks tend to sell off in tandem. Breadth will be poor, and there will be few safe-havens. In healthy markets, there will be rotational action as more extended stocks are sold, and buyers look for good entry points in new names. When selling becomes increasingly lopsided, then it's time to be more defensive.
This is to look at intraday reversals. Quite often, market tops start to develop when there is a high level of intraday reversals. When traders become more aggressive about selling into strength and stocks go from green to red, it can trigger a shift in momentum. In recent years, gap-down opens are almost always met with buying. It has become almost automatic, and if you try to short into a poor open, you will likely have problems. It is when the selling occurs in the middle of the day and stocks close near the lows that it is more likely that downside action will build.
Finally, watch for failed bounces. Downtrends are ultimately the product of lower lows. When bounces fail and the prior lows are breached, that is when downside momentum can build. We had a good example of that back in February and March when the Covid crisis hit, but we have not had any real sustained selling since the top that occurred in early September.
I'm not suggesting that now is the time to take action, but there are a few issues developing that require our attention. The market may just shrug it off and keep running, but we do need to stay vigilant and watch for the four warning signs above.
