What History Says About Market Tops

03/16/2015 9:00 am EST

Focus: STOCKS

James Stack

President, Stack Financial Management

There are many historical truisms on Wall Street, including “Don’t fight the Fed" or “Sell in May and walk away”—but one truism that is not well known is, “Be quick to turn bullish and slow to turn bearish”—asserts market historian Jim Stack, editor of InvesTech Market Analyst.

In fact, it’s a lesson I learned by both research analysis and experience over multiple market cycles, including the Tech Bubble of the late 90s. If you look at a wall chart of market averages over the past 80 years, you’ll quickly notice that bear market bottoms are “V” shaped affairs.

This is caused by the sudden reversal of investor emotions from the “fear of further losses” into the “fear of being left behind.” When a new bull market is launched from extreme oversold conditions, the majority of investors are left behind in the dust.

Consequently, at the depths of a bear market, the most prudent strategy for a defensive investor with a high cash position is to start nibbling at great stock values even before the confirmation that a bear market bottom is in place. That is exactly what we did in late 2008 and early 2009.

Conversely, bull market tops are characteristically slow “rounding” formations. The reason is that widespread bullish optimism at a market peak is difficult to kill.

In most cases, it gradually transforms into doubt, then disappointment, then disillusionment, and finally outright fear that a bear market might be in control.

To prove this point, we constructed a mathematical composite of all the bull market tops dating back to 1950. We excluded the 1987 Crash because the extreme loss of Black Monday distorted the average top perspective.

The important message is that there is usually a 6+ month period surrounding a market top which provides observant investors an extended opportunity to build bear market defenses.

While it might be nice to exit at the very peak of a bull market, in reality, very little profit is left on the table by not selling at the exact high, and that is minor in the context of a major bear market where losses can exceed 35%-40%.

So now you understand why we continue to give this current bull market the benefit of doubt, even as our nervousness continues to increase.

In our view, a bear market is definitely looming out there and will most likely start in the next 6-18 months.

But until warning flags appear, we do not know if it will be on the closer or longer end of that range…or whether today’s unique circumstances might extend this recovery and bull market even further than we suspect.

The only fact that is certain is that no one has repealed the economic cycle and that another bear market lies in the not-too-distant future.

Subscribe to InvesTech Market Analyst here…

More from MoneyShow.com:

Bonds: "Uncharted Waters"

Bubbles, Bears, and a Case for Gold

No Shine for Gold

Related Articles on STOCKS