Coppock Curve: Caution Sign?

10/23/2013 9:00 am EST

Focus: STRATEGIES

James Stack

President, Stack Financial Management

With the DJIA above 15,000, it might seem that stocks have clear sailing ahead. And indeed, that might be the case. However, we suspect this isn't the time to lose sight of which deck the lifeboats are located on, advises Jim Stack in InvesTech Market Analyst.

There are some dark clouds developing over this stock market that raise caution flags in our longer-term outlook. So, rather than jumping on the DJIA 20,000 bandwagon, we present this negative evidence for the sole purpose of keeping our feet objectively planted on firm ground.

One such caution flag is The Coppock Guide or Curve, which was originally developed over 50 years ago by Edwin S. Coppock. It's been described as a barometer of the market's emotional state, methodically tracking the ebb and flow of equity markets from one extreme to another.

By calculation, the Coppock Guide is the 10-month weighted moving total of a 14-month rate of change, plus an 11-month rate of change of a market index. In simpler terms, it's really just a momentum oscillator.

Because of this, it reverses direction when the momentum or rate of change in the market reaches a peak or a trough.

The historical value of the Coppock Guide lies in signaling or confirming low risk buying opportunities that emerge once a bear market bottom is in place (black dotted lines on graph below).

And since market bottoms are usually sudden, or spiked reversals, the Coppock Guide works amazingly well—as it did immediately after the bottom in 2009.

Once the Coppock Guide drops to '0' or below, a mere 1-point upturn can usually be treated as an excellent buying opportunity. And often, the more negative the Coppock Guide is when it turns upward, the more impressive the profits ahead.

The only four false signals under this guideline were in 1938, 1941, 1947, and November, 2001.

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Click to Enlarge

The Coppock Guide has never been noted for timely sell signals. The reason is that market tops are usually slow, rounding formations in which momentum (and the Coppock) peak up to a year or more ahead of the market. Except, that is, in a few cases...

In the late 1960s, a technician named Don Hahn observed another phenomenon about the Coppock Guide. When a double-top occurs without the Coppock falling to '0', it identifies a bull market, where corrections haven't driven out nervous investors or cleansed excesses from the market.

When those psychological excesses are not washed out, the nervousness can continue to build and extremes can multiply...with the result that the next downturn can become severe, as everyone heads for the exits.

So there is a critical historical aspect to double-tops: They can result in nasty bears! Double-tops have occurred only seven times in 93 years—with five of them accompanying the start of the most notorious bear markets of the 20th century: 1929, 1969, 1973, 2000, and 2007.

The severity of those resulting bear markets reveals why the double-top in the Coppock Guide has been nicknamed a “Killer Wave.” The average decline (excluding the -86% loss in 1929) was almost -42%!

Over the past few months, the Coppock Guide has been developing a second peak (yellow shading), raising the odds that when the next bear market does strike, it could be more devastating than many anticipate.

However, since the Coppock is still in an upward trajectory, it's not pointing toward an imminent bear market today. Yet this does suggest that we should be extra vigilant and avoid taking excessive risk in this aging bull market.

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