Warning: The End Is Near (And What To Do About It)…

“The end is near” is a popular theme in The New Yorker cartoons. One shows a man carrying a sign warning that end is near while a second man asks if that’s a good or a bad thing. That’s the question for the stock market this week.

The chart below shows that the end is near. It’s a chart of the Invesco QQQ Trust (NASDAQ: QQQ), an ETF that tracks the Nasdaq 100 Index. A 52-week rate of change (ROC) indicator is at the bottom of the chart. The dashed line is at the key 40% level for the indicator.

The Nasdaq 100 is among the most speculative indexes. Its top 10 holdings include favorites like Apple, Tesla and Facebook.

Source: Yahoo

ROC is a simple measure of momentum. Unlike more popular momentum indicators like stochastics, it isn’t forced to stay in a range. This means ROC measures market action directly.

It’s also not smoothed like stochastics or other typical momentum indicators. That means ROC is more responsive to the market action.

However, because it’s not popular, there are no simple rules to interpret ROC. Traders need to study the indicator on their own to learn how to use it. My research reveals it is an excellent bubble indicator.

[Related: Why I Think The Rally Is Nearing A “Top”]

What This Means

When the 52-week ROC tops 40%, we’re most likely near the end of a bubble. There’s a fundamental reason for this. Fundamentals, like earnings, are based at least in part on economic growth. The economy tends to change slowly. So, the rate of change for earnings should also be relatively slow, shown by a low number on the indicator.

The ROC of the stock market reflects this. Prices change because of increases or decreases in earnings and a sentiment factor that assigns a multiple to those earnings. When prices rise sharply, it usually means earnings have increased and investors are bullish which increases the fundamental value of stocks.

Because the economy changes slowly, the portion of the ROC due to earnings changes is relatively small. Generally, less than 10%. That means most of the changes in ROC are due to shifts in sentiment.

Extremes in sentiment are difficult to sustain and when they reverse, there is often a change in the trend of the stock market.

Testing shows ROC changes above 40% are rare, and an important indicator. That makes sense because fundamentals will rarely justify a one-year gain of more than 40% in the stock market.

Buckle Up…

The chart above shows just four times in more than 25 years when the ROC exceeded 40%.

The first instance came as the stock market bubbled higher in the late 1990s. The second came as stocks recovered from that bubble in early 2003. The next time was after the bottom in 2009 and the fourth time is right now.

In the previous examples, the trend changes after prices moved back below 40%. The trend turned down in 2000 and sideways in 2003 and 2009. This is an example of why it’s important to remember there are three trends in the market – up, down, and sideways.

The indicator’s current reading of 46.9% tells us the end is near. A move below 40% will indicate the uptrend is almost certainly over. However, the extreme bullish sentiment required to keep this indicator above 40% could hold up for months.

Closing Thoughts

ROC tells us the bull market is coming to an end; however, it doesn’t tell us in advance when that will happen. This is a lagging indicator but it is still useful. I’ll be watching for the end and will keep you updated.

My other indicators confirm the message from ROC. As I’ve noted in recent weeks, my Profit Amplifier Momentum (PAM) indicator and Income Trader Volatility (ITV) indicator both indicate a large move is likely soon. Both of these tell us a down trend is more likely than a sideways trend.

That’s why I want to remind you that endings can be good for investors. As I searched for some more of those classic “end is near” cartoons, I came across another one. First, we have the man holding the usual sign. But next to the sign warning of the end is another man holding a sign “great deals are nearer.”

That’s the position of the stock market. Great deals are near, as long as we avoid the manic phase that comes as bull markets end in bubbles.

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