Calling the Top

The SP500 and the DJIA topped out on a closing basis on 8/6/97. The significance of this top is yet to be seen. As of this writing (10/7/97), the SP500 has recovered all of its losses but the DJIA is still below its highs. At its worst, the SP500 fell 7.4% and the DJIA dropped 8.3%.

Did we call this top? Yes we did. Below are the details on how and why we did.

Our first clue was a momentum divergence in late June. Basically, the speed of the market's advance was slowing down, even as the market hit new highs. Momentum usually peaks before prices, so when we saw a momentum peak it raised a warning sign. We pointed this out in our 6/29/97 Trader's Weekly:

However we do see some dark clouds. Last week we thought it looked like we might have had a momentum peak on 6/13. Remember that momentum usually peaks before price. We also have some pretty weak looking internals. So while we are short term bullish, we are looking for a price peak to go with that momentum peak that we had on 6/13.

Trader's Weekly, 6/29/97

Here is a chart of what we were looking at when we wrote the above. Mom13 is one of our favorite momentum indicators. Point "1" is in early May. Mom13 is peaking at the same time that the SP500 is setting new highs. This is a healthy market and everything looks rosy. But at "2", the market is hitting new highs while Mom13 is significantly below the "1" point. This is a classic momentum divergence.

The next week we saw some more ominous signs. As the SP500 and DJIA moved rapidly higher, the market internals (up and down volume, advancing and declining issues) were lagging badly. This type of divergence is very ominous. From our 7/6/97 Trader's Weekly:

Market price action is going nuts. Internals are lagging and diverging quite significantly. Look at the McClellan Osc at 77. It was at 139 when momentum peaked on 6/13, and it was at 235 on 5/5. Successively lower peaks on higher prices. Momentum peaked several weeks ago on 6/13. And sentiment appears to be wildly bullish. This has us looking for a price peak that will mark a trading top.

Trader's Weekly, 7/6/97

Below is a chart of one of our favorite internals indicators. Once again, you will note the lower peak at point "2" than at point "1". By this time we also had another lower peak at point "3" to worry us.

Here is another internals indicator, the McClellan Oscillator. This is a fairly common indicator, and many of you are probably familiar with it. The McClellan Oscillator was telling the same story as the rest of our internals indicators:

A few weeks later these divergences had grown worse. See point "4" in all the charts above. All of our market internals indicators were now dropping even as prices hit new highs. Momentum had peaked long ago. These divergences had developed to such a point that we felt comfortable calling a top in our Trader's Weekly on 7/27/97:

Looking closely beneath the surface of the market we see two sets of momentum divergence's. First, we have a peak on June 13th that marked our major momentum crest. Second, it appears that we had an intermediate term (several months) pinnacle in the longer term oscillators July 16th. The bulk of the indicators have now changed direction and are rolling over so we feel that the market will soon follow.

Trader's Weekly, 7/27/97

We also warned of this top in our Walker Market Letter from 8/1/97. The Walker Market Letter has a long term orientation suitable for investors (as opposed to the traders that it's written for), so we usually don't make a habit of trying to call tops and bottoms. But in this case the evidence for an impending trading top was too much to ignore, so we warned our subscribers:

In the short term, we would be surprised if there isn't some price pull back soon. Several of our shorter term internal measures are showing some weakness hiding just below the surface of this market. Whether this expected drop will develop into something more significant is difficult to say right now.

Walker Market Letter, 8/1/97

When the above was written, the SP500 was at 954 and the DJIA 8222. The all time highs came just 4 trading days later at SP500 964 and DJIA 8299. In the next three weeks the SP500 dropped more than 70 points (7.4%) and the DJIA dropped more than 680 points (8.9%).

So there you have it. Good old fashioned technical analysis at work. Roll up your shirt sleeves and get 'em dirty. No neural nets, fast fourier transforms, or adaptive moving averages. Was it a fluke? No, all those same divergences were in place in March when we called that top. But that story will have to wait for another day...

Interested in our Trader's Weekly now? You can get a four week free trial if you click here.