Is The SP500 Forming a "Triple Top" Pattern?
In our last blog post, "Charting the Key Levels in the Nasdaq", we showed important long-term chart patterns and trendlines in the Nasdaq, including a little-known rising price channel that the Nasdaq has remained within for the course of its four-year old bull market, as well as a possible (but still-unconfirmed) bearish "Head and Shoulders" pattern that has formed over the past year.
In this post, we'll be taking a look at a long-term potential pattern in the SP500 called a "Triple Top", as you can see in the chart below:
"Triple Top" patterns are very common market topping patterns (like their similar-looking cousin, the bearish "Head and Shoulders" pattern) and occur when a market makes three attempts to reach a new high, but fails at the same price or resistance level each time. In the Sp500's case, the resistance level is the 30-point zone between 1,550 to 1,580. The last two attempts that the SP500 made to breach the critical 1,550 to 1,580 zone were in the year 2000, before the Dot-com Bubble popped, and in 2007, before the U.S. housing bubble popped and led to the Global Financial Crisis.
After three failed attempts to rise above an important long-term resistance level, markets become exhausted and discouraged, and then often embark on a correction or bear market phase. The chart below shows how typical "Triple Top" patterns look:
Chart Source: AshiInvestments.com
A Valuation Analysis of the Market
When analyzing financial markets, it is important to utilize fundamental analysis (analysis of financial and economic data) in addition to technical analysis (analysis of chart patterns and price-based technical indicators). The combination of these two forms of analysis helps traders to form more robust and accurate market outlooks than if they only used one form of analysis to the exclusion of the other.
So, what is fundamental analysis telling us about the SP500's potential "Triple Top" pattern? Interestingly, a broad market valuation measure called the "Tobin's Q Ratio", which has spotted every important generational stock market top of the past century, shows that stocks are quite expensive and comparable to past valuation levels that occurred at important prior market tops:
Chart Source: Doug Short, Advisor Perspectives
A historically-successful investment strategy is to buy stocks when the Tobin Q-Ratio is low, like in the early-1950s and early 1980s, and sell stocks when the Q-Ratio is high, like in 1929, the late-1960s and in 2000.
Market Sentiment Analysis
Another important type of market analysis is called "sentiment analysis" and looks at data that measures investors' opinions and feelings about the markets. When investors and traders become excessively bullish, the market tends to decline shortly after, and when they become excessively bearish, the market tends to rise shortly after. Traders who do the very opposite of the "crowd" during times of extreme sentiment are called "contrarians."
One of the most popular sentiment indicators is called the Volatility Index, or the "VIX" for short, and measures the sentiment levels of stock options traders. When the VIX is high (typically over 40 in the index), investors and traders are fearful of a market decline and become heavy buyers of "put options" to protect their portfolios against a market decline. When the VIX is low (typically below 15 in the index), it's a sign that traders are complacent, and aren't buying many put options because they expect the market to continue to rise.
The chart below compares the SP500's chart (top) to the VIX (bottom) and shows how extremes in sentiment tend to herald important contrary market moves. The VIX is currently at 13.53 (click here for current quote), which tells us that the market is quite complacent, though it's important to note that this complacency can last a while, as it did in the prior bull market cycle from 2004-2007.
Source: Carl Swenlin
Margin debt levels (when traders borrow from their broker to speculate in stocks) is another popular sentiment indicator, as margin levels rise when traders are placing aggressive, leveraged bullish bets. When margin debt levels hit extremes, as during the prior market peaks in 2000 and 2007, it tends to be a reliable signal of a market correction ahead. Take note of the fact that the prior margin debt level peaks perfectly coincided with the market peaks in the first SP500 "Triple Top" chart in this post. As you can see from the chart below, margin debt is, once again, at the same levels that it was in 2000 and 2007:
Chart Source: BofA Merrill Lynch Global Research
RBC Capital Markets publishes a sentiment indicator that is a composite of other popular sentiment indicators, and it is also showing an extreme in bullish sentiment:
Chart Source: RBC Capital Markets
Another accurate indicator, though not a sentiment indicator, is U.S. average retail gasoline prices, which have warned of market corrections when gasoline prices rise above the "danger zone" of $3.75/gallon. Gasoline prices very close to being in the "danger zone", as you can see from the chart below:
Chart Source: LPL Financial
To summarize, the SP500 may be forming a bearish "Triple Top" pattern, but more confirmation is needed on a shorter time-scale before we would consider shorting the market. We must also consider alternative scenarios in which this "Triple Top" hypothesis is wrong such as:
Alternative Scenario 1: The SP500 manages to successfully break above the long-term 1,550 to 1,580 resistance level. If this were to happen, it could be a strong indication that the bull market will continue, and even accelerate.
Alternative Scenario 2: The SP500 tries to breach the 1,550 to 1,580 resistance level, but fails, leading to a shallow market correction that helps to reduce the extremely bullish sentiment levels, setting the market up for a final successful surge above the long-term resistance level.
We are not making any firm market predictions, because we are traders, first and foremost, and we trade with the prevailing market trend, instead of fighting it. The purpose of these blog posts is to show possible scenarios of how the market may play out, without saying that any one particular market scenario will play out.
Also, nothing within this post should be taken as investment advice or a recommendation to buy or sell any investment, as it is for educational purposes only.