Ritholtz - Why Is Calling a Market Top So Hard?

June 10, 2014
By Barry Ritholtz
Bloomberg.net

Each morning, I go through a similar routine: I wake up (no alarm clock), go to the kitchen to get a cup of coffee (this is my machine of choice lately), launch a script that opens 40 or so Firefox tabs. As part of my morning research, I quickly scan this series of websites to see what happened overnight, and what might be interesting.

Part of that list is Jason Zweig’s "This Day in Financial History,'' which led to this morning’s gem: Today in 1997:

The Dow Jones Industrial Average closes above 7,500 for the first time, and The Wall Street Journal notes that the market’s climb ‘seems to inspire equal parts awe and dread among many investors.’ Fred Taylor, CIO at U.S. Trust, guesses that the stock market will end the year ‘lower than its current level.’ (The Dow finishes 1997 at 7908.25, or more than 5% higher.)

Which leads to today’s question: Why is calling a top so much more challenging than seeing a market bottom?

I don’t think many traders would disagree with that notion. It is often said that “Tops are a process while market bottoms are an event.” Or as Michael Batnick observed, “Bull market tops are more difficult to call than bear market bottoms because doubt is a far more resilient emotion than hope.”

Allow me to rephrase that without any of the lovely subtlety I am known for: The dominant emotion at bottoms is fear -- a palpable and very recognizable state. Tops on the other hand, come about through the combination of greed, complacency and indifference. This is a much more challenging set of factors to identify. Indifference does not cause a huge spike in VIX, a standard measure of market volatility; volume does not increase as traders become complacent.

There are many other forces at play:

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

You don’t remember those calls because an endless stream of bad forecasts crosses your desk every day.

The future is unknown: The world is a complex place. Most people really don't understand what has already happened. We have a loose understanding of recent events, but we are far less informed than we believe. Discerning what is going to happen is an almost impossible task.

The bottom line is that these market calls are at best one part art, one part science. Whatever market calls people choose to make (or follow) it helps to understand this: No one is infallible, most are pretty bad, few are consistent. Luck plays a huge part as well. Even those who occasionally get it right are no more likely to continue that streak than anyone else.

I have no idea when this market will reach a top; it could have been yesterday for all I know. But I can tell you that if your investing process is highly dependent on correctly identifying when a market is about to top and reverse, I expect you will need new investment plan eventually.