Is the Stock Market Heading Toward a Blow-off top and If So What Does That Look Like?
The good news is, we have a tool to measure extreme market moves; the bad news is because the future is dependent upon unknown decisions made today it is unknowable. However, we can observe fear and greed, and we can define when those distinctly human emotions reach extremes. There is a plethora (yes, a plethora) of research on financial market bubbles, but for BK’s purposes he likes research that is objective, can be replicated and can be tested. Those who want a deep dive should read the work of both Jeremy Grantham and Cliff Asness, both have done groundbreaking work.
In the simplest terms, the extremes of fear and greed can be observed when markets stray far from equilibrium. We can define equilibrium as the trend and the extremes as a 2 standard deviation move from the trend. Armed with these definitions we can look back at bull markets and look for similar patterns of human behavior.
If the research and BK’s thesis are valid then what we should observe is that major stock market tops occur when the price reaches an extreme (defined as 2 standard deviations from the trend). Let’s go to the charts.
BK used the Dow Jones Industrial Average because of its long history. The following charts are of every major bull market since 1921 overlaid with a regression channel. The middle line of the regression channel is the trend and the upper and lower lines mark a 2 standard deviation from the trend.
What do every single one of these bull markets have in common? They all ended with a blow-off top that resulted in the price breaching 2 standard deviations from the trend.
What does the DJIA look like today?
2009 – 2017
Based on this single indicator one might conclude that the DJIA would need to breach 21k before we could define this move as a blow-off top. To repeat what BK wrote earlier – the future is unknowable – but if the DJIA breaches 21k AND we see a deteriorating economic landscape then the conditions would replicate every other blow-off top.