Calling a Top in the Equity Markets

Andy Waldock |

Back in the old days when the trading pits were full of people executing trades we had a saying, “The market always finds the orders.” This is quantified by the market through the comparison of volume and open interest levels against the price levels that generated the activity. The first rule of trend trading is that growing volume and open interest supports the market’s current direction. Last week we discussed the idea that the stock market may be establishing a late summer high with probable declines into fall from a big picture outlook. This week, we get technical.

Monday, August 5th, the S&P 500 futures traded approximately 850k contracts. Only one normal trading day in the last few years has done less volume than that. Typically, we’re looking for twice that much trading on a normal day with bigger days eclipsing the 3 million contract mark and big days reaching over 6 million like we did during the August sell off in 2011. Monday’s volume more closely matched the Christmas and New Year averages around 600k. Low volume is usually accompanied by low volatility and Monday’s trading range of was the smallest since August of last year and all the way back to April of 2011 before that. Thus, even the holidays of recent years generated more market movement.

Lower volume doesn’t always mean dying trends. There are times in a market’s trend typically, following the accumulation phase when volume will decline but open interest grows as the market begins its march in small orderly steps. Unfortunately, this is not where we stand within the equity markets’ current trend. The S&P 500 futures expire quarterly. Therefore, those who wish to maintain a position going forward have to re-establish it as their current contracts approach expiration. Those who do not may simply let their contract expire. Market participation in the futures markets is measured by open interest. Theoretically, open interest has no upside limit. As long as two new people come to the market and negotiate a trade, open interest will increase by two. One new person (long) is making a bet on higher prices going forward while the other new person (short) will profit from a falling market. Open interest in the S&P 500 futures is at its lowest levels in over a year. This means that the current market price is completely uninteresting to potential market participants.

This leads to the obvious question, “If the market is uninteresting, who’s trading?” We began to answer this question last week in our discussion of margin buying and human nature’s, “catch up” instinct. Margin buying in the stock market is borrowing money from your broker who charges you interest so that you can buy more stock than the available cash value in your account will allow. There have been four all-time highs in margin buying – 10/1987, 4/2000, 9/2007 and right now. The previous peaks all led to declines of at least one third within next 12 months. Remember the leveraged nature of the housing bubble? Leverage begets leverage…until it crumbles. Commercial traders and their large bank accounts have gladly sold all that the public wishes to purchase at these levels.

Finally, we have current technical and pattern analysis that clearly believes there is more money to be made on the expectation of downward pressure on the stock market rather than continuation of the upward trend we’ve been experiencing. One of the primary tools I utilize is the analysis of divergence. The idea is to gauge the market’s momentum by measuring various calculations against each other. The results are then plotted below the chart and we simply look for a market that has made a new high or low without a momentum confirmation. The all time highs made in the S&P 500 last week have not been confirmed by any of the popular indicators and their textbook, default settings. Meanwhile, pattern analysis shows that we have just created a broken cup with handle formation. This is a normally bullish formation gone wrong due to the currently overpopulated and leveraged speculative participation rate.

Owners of equities, mutual funds and their equivalent ETF’s should seriously take note of the warning bells. If recent history has taught us anything, we should know that six years of nowhere to new highs can be an emotionally traumatic interim. I’m not suggesting dumping the family holdings whose cost basis is now next to nothing. I am suggesting that those who’d like to sleep peacefully should look into the various ways of providing downside protection for their portfolios with advisors they trust. Insanity is doing the same thing repetitively while expecting different results. This time may be different but I’m not betting on it.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
EGHSF Enghouse Sys Ltd 38.50 0.00 0.00 0

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