I first leaned about this signal from reading Jim Roger’s Adventure Capitalist, but I’ll expound on it in more detail in this post. In a great bull market, we all want to avoid the peak (at least if you’re long).
I’ve divided stocks in a bull market into 3 groups, or “waves”.
Wave 1 is the first group of stocks to go up. These are the stocks that are the first to go into “bubble mode”, and rise the fastest in the least amount of time. Additionally, these stocks are usually low market cap, because small stocks are easier to be speculated by a few smart investors. These stocks were the original market leaders. Next you have “wave 2”, which are medium sized stocks. This is the second wave of stocks to go into “bubble mode”. And lastly, you have “wave 3”, which are the big, institutional stocks like Wal-Mart, McDonalds, IBM, etc.
A key sign that the bubble is over is when wave 1 falls. The original market leaders are no longer leading, but instead lagging. Wave 1 falls the fastest and earliest, because they’re owned and dominated by a few, large investors/funds. This indicates that the smart investors have gotten out. So now, wave 2 are the market leaders. But eventually, wave 2 stalls and falls. This is a very, VERY dangerous sign, because it indicates that not only has the smart money left, but many hugely successful individual investors have gotten out to.
In the end, what you have is wave 3 that’s still hanging on up there. Because wave 3 consists of large, institutional stocks, they are the hardest to move. Because they’re the hardest to move, they fluctuate the least, whether it be on the long or short side. There’s no smart money left at this stage, but the public is still frantic to buy, Buy, BUY! Obviously, they’ll buy the big name, everyone-knows-them stocks. So what you have is the smart money selling to the dumb money, which is the public, who are keeping the index from falling.
While the rest of the index is already on the decline, these big names are holding up the average. Remember the Nifty Fifty in the 1970s?