David Merkel | Apr 16, 2013 02:52AM ET
Watch out for a momentum-driven investor base.
Companies will take advantage of a topping market by raising cash.
A top in the market is not imminent.
I am basically a fundamentalist in my investing methods, but I do see value in trying to gauge when markets are likely to make a top or bottom out. The methods that I will describe in this column are somewhat vague, but I always have believed that investment is a game that you win by being approximately right. Precision is of secondary importance.
At the end of this column, I will apply my reasoning to the current market to show what concerns exist and why there is reason for optimism.
The Investor Base Becomes Momentum-Driven
Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
You’ll know a market top is probably coming when:
Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.
Here are ways that corporate behaviors change near a market top:
In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.
Other Gauges
These two factors are more macro than the investor base or corporate behavior but are just as important.
Near a top, the following tends to happen:
One final note about my indicators: I have found that different indicators work for market bottoms and tops, so don’t blindly apply these in reverse to try to gauge bottoms.
No Top Now
There are reasons for concern in the present environment. Valuations are getting stretched in some parts of the market. Debt capital is cheap today. There are an increasing number of momentum investors in the market. Making the earnings estimate is once again of high importance. Nonetheless, a top in the market is not imminent, for these reasons:
Not all of the indicators that I put forth have to appear for there to be a market top. A preponderance of them appearing would make me concerned, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me out of the trouble in 1999 and 2000. I hope that I — and you — can achieve the same with them as we near the next top.
The current market environment is not as favorable as it was a year ago, but there are still some reasonably valued companies with seemingly clean accounting to buy at present. Right now, being long the market is more compelling to me than being flat, much less short.
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