Different markets make different kind of tops. For example, commodities’ bull markets typically end in a spike. Here’s an example with gold.
The U.S. stock market is different. Its bull markets typically end with a relatively flat top that rolls over. Here are the historical examples.
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There are a few reasons why equities tend to make flat tops that roll over.
The U.S. stock market moves in sync with the economy over the long run
The state of the U.S. economy changes slowly over time. As a developed economy, the U.S. doesn’t go from “rapidly expanding” to “rapidly contracting”. Instead, the U.S. economic expansion will accelerate, decelerate, then slowly deteriorate until it contracts (recession). The economy’s slow changes cause the stock market to make a slow and flat topping process.
A lot of “dumb money” buys the dip
Investing and trading the U.S. stock market is easy. The real-time economic data leads the stock market. The stock market will only top AFTER the economy has deteriorated. Sometimes the economic deterioration is insanely obvious before the stock market tops. Why?
Because there’s too much dumb money in the stock market. Too many investors “buy the dip” and ignore the deteriorating fundamentals. Their buying the dip prevents an initial stock market decline from turning into an instant crash. Only after a few “buy the dips” and no new highs will the dumb money realize that the market’s underlying trend has changed. Hence, the stock market makes a relatively flat top, slowly goes down, and then accelerates on the downside when the dumb money can no longer ignore the deteriorating fundamentals.
It takes time for investors to go from being bullish to being bearish.
The U.S. stock market has a long term bullish bias. It goes up (60% of days) more often than it goes down. Bull markets also last a lot longer than bear markets. By the final stage of a bull market, all the bearish investors and fund managers have either given up or are unemployed.
As a result, most investors have a strong subconscious bullish bias by the end of a bull market. It takes months for them to switch from a bull market mentality to a bear market mentality.
The problem with head and shoulder patterns
With the U.S. economy making flat tops, one would think that head-and-should patterns are useful for catching market tops. I don’t think so.
Head and shoulder patterns tend to be 20/20 hindsight. In the stock market, almost all tops can be classified as head and shoulder bearish patterns. But there are too many false signals. There are too many fake “head and shoulders” that turn into bull market continuation patterns. You can’t tell the difference between real and fake head and shoulder patterns until the stock market has already made new highs.
For example, the S&P might make a right shoulder and break below the neckline. Based on the head and shoulders pattern, this means that the bull market is over. Then the stock market will surge to a new all-time high, thereby invalidating the head and shoulders pattern. You can’t use head and shoulder patterns to catch bull market tops.