Why Is Calling a Market Top So Hard?
Here is a section from another interesting column from the topical and prolific Barry Ritholtz, published by Bloomberg:
Risk aversion: This plays a large part in the differences between tops and bottoms. After a market drops 25 percent or more, the recency effect weighs heavily on investors. We dread losses at about twice the rate that we desire gains. That asymmetry leads to a variety of investing behaviors.
Because of this, we feel the losses of the big 2008-09 crash more intensely than we feel the gains of the 2009-2014 rally.
Biased perspective: Anyone with an investment in the market has a bias. It isn't a good or a bad thing; it simply is the way you are wired. Most investors who are long equities expect the market to go higher. Those who are out of equities, or (heaven forbid, short) believe that stocks will go lower. Hence, these market calls often reflect investors talking their book. I was reminded yesterday of an old joke about bubbles, as Art Hogan noted: “An asset bubble is an asset that is rising, that you have not invested in.”
Not rigorous: Most of the calls for a market top in this cycle haven't been very rigorous. Lots of gut feelings, sensations, and instincts, which history teaches us are a surefire way to lose money in markets. Contrast that with the analysis that Paul Desmond employs, using quantifiable metrics. That is a very different approach than merely guessing.
Fear is more visible than greed: During crashes, lots of metrics light up. I can give you a list of technical and sentiment measures that all pin the needle during a crash. On the other hand, the view from tops is much more nuanced.
No downside for pundits: Making a big splashy forecast almost guarantees calls from news media producers and naïve reporters. If by some stroke of luck, a talking head gets it right, it makes his career. On the other hand, few remember that wildly wrong money-losing call made on TV. Quick, name the person who said five years ago that hyperinflation would be the result of QE. Who noted a 1987 like crash was imminent every year over the past four years? Which pundit forecast gold at $5,000 an ounce?1
Here is Barry Ritholtz's article.
Every experienced investor will be able to cite other clues, often behavioural, that may be evident at market tops or bottoms. Here are a few:
1) Dramatic trend acceleration, up or down, is climactic. This can only be seen in perspective by looking at price charts, preferably weekly candlesticks with a 200-day MA representing the approximate trend mean.
2) Extreme trend extrapolation forecasts are a feature of market tops and bottoms. This is not necessarily because people are stupid but it does indicate that they lack emotional intelligence. If people think that the market can only go slightly higher, they must feel that they are taking a big risk by not reducing exposure. They may lower their anxiety by listening to bolder forecasts from people who seek to attract attention. Also, people can become market junkies near bull market highs, seeking yet another fix in their pursuit of additional financial security.
3) Inexperienced investors will often panic near market bottoms. More importantly, fund managers may be forced to sell to raise cash for redemptions. The last thing any investor wants is to sell near the bottom and see markets surge higher. Consequently, they will repeat the views of congenital bears who sadistically forecast significantly lower prices. Hellfire and brimstone forecasts also have a masochistic appeal for investors who are emotionally flogging themselves for losing money.
How can we avoid these tortures?
Buy low and sell high.Back to top