It’s said that all good things are worth waiting for. Even though waiting is so yesterday in a world of instant gratification, there’s no doubt that patience in investing remains a virtue.

There’s one very specific timeframe in the market’s boom and bust cycle that requires more patience than any other – the topping process - and I believe we are there right about now.

Unfortunately, tops are tougher to call than bottoms. Here’s why I think yet another top is forming and why it will be difficult but rewarding to sell stocks and/or go short.

Bottom Fishing … October 2011

I don't know why but calling a bottom comes easier to me than calling a top. This could be due to a variety of reasons; I happen to believe that calling a bottom is more “scientific” than calling a top.

Using the October 2011 bottom, allow me to explain what I mean by “scientific”. From May to August, the S&P had lost as much as 270 points. On August 12 the S&P closed at 1,178.

Via the August 14 ETF Profit Strategy update I listed 5 reasons why the S&P will make a new low before the next multi-month rally. The reasons were:

1) Sentiment
2) Seasonality
3) Elliot Wave Theory
4) 200-day SMA death cross
5) The VIX
The August 21 ETF Profit Strategy update added # 6) RSI

The two most “scientific” of the above points where the VIX and RSI. Here’s what was stated about the VIX in the August 14 update:

“The VIX high generally does not coincide with an S&P bottom. Neither the October 23, 2008 nor May 21, 2010 VIX highs marked an S&P low. There was a 21-trading day lag time between the VIX high and the S&P bottom in 2008 and a 28-trading day lag time in 2010. Based on this pattern a new price low may occur in 17 – 24 trading days.”

In other words, the VIX suggested a new price low for the S&P (SNP: ^GSPC) unconfirmed by a new VIX low.

Here’s what the August 21 update stated about RSI: “My analysis shows that there tends to be an RSI and general breadth divergence (see August 8 TF) whenever significant lows are reached. It would therefore make sense to see a new price low unconfirmed by a new RSI low.”

The expected new price low occurred on October 4, 2011 when the S&P briefly dipped as low as 1,075. The October 4, VIX high of 46.88 remained below the September 8 high of 48. The October 4, RSI low of 40 remained far above the September 8 low of 20. The October 4, bottom adhered exactly to all expected parameters. The chart below illustrates the RSI divergence. 

In addition to the above-mentioned studies, the S&P was also close to crucial support at 1,088. The October 2 ETF Profit Strategy update outlined the ideal bottoming scenario: “The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.”

… March 2009

My call of a major market bottom in March 2009 was mainly based on extremely bearish sentiment. The March 2, 2009 Trend Change Alert recommended to buy the S&P (SNP: ^GSPC), Dow Jones (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC), Russell 2000 (NYSEArca: IWM), financials (NYSEArca: XLF) and corresponding leveraged ETFs and stated that:

“This counter trend rally will have to be broad and powerful in order to relieve investor's pinned up urge to buy. Nevertheless, keep in mind this will be a counter trend rally, the down trend will resume once the rally exhausts itself. This point of exhaustion is likely to happen at a point where optimism takes over and investors think that the Q1 2009 lows are here to stay.”

Fishing for a Top

Even though RSI divergences can suggest a market top, they can go on for longer than expected. There is no specific VIX pattern that suggests a top and sentiment, even though bullish already, can always get more bullish.

QE2 made it difficult to pick a top in 2010/2011. If you subscribe to the ETF Profit Strategy Newsletter or read any of my articles you know that I was early in suggesting a market top until I realized that it’s foolish to fight QE2 (I shared my “aha experience” in the October 15, 2010 Newsletter).

Higher prices were likely in late 2010 and even after the March 2011 Japan earthquake correction, the April 2 ETF Profit Strategy update pinpointed the next target for a top: “In terms of resistance levels, the 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions.” On May 2, the S&P briefly spiked to 1,371 before assuming its painful 300 point or 22% summer decline.

After finding a bottom, the October 4 update outlined the target of the current rally: “From a technical point of view this counter trend rally should end somewhere around 1,275 – 1,300.” Via the October 11 update I admitted that: “This rally from the 1,075 low is a miniature version of the March 2009 – May 2011 rally. I expect some difficulties in forecasting the exact route of this rally.”

The Reward of Fishing for a Top

What’s the point of bucking the trend and fishing for a top? All good things are worth waiting for. The “good thing” for investors willing to buck the prevailing trend/opinion and go short in 2011 was a 22% (300 S&P points) top to bottom decline.

250 of that 300-point loss, or 76% of the entire decline, happened within 12 trading days. Bear markets are faster than bull markets and can be hugely profitable (or devastating if caught on the wrong side). Stocks take the steps up and the elevator down.

Regardless of the reward, picking the top remains tricky. The 2011 topping process has taught us some valuable lessons on trading in such a market.

Low-Risk Strategies

The most important rule is to limit risk. The best way to limit risk is to identify strong resistance levels. Resistance levels often work like price traps. They attract their prey and then kill the up trend. In other words, they attract prices before repelling them.

The low-risk strategy is to sell long positions against resistance and initiate short positions with a stop-loss just above resistance. Another low-risk strategy is to go short once a major index falls below support with a stop-loss above support.

2011 – 2012 Comparison

Here’s a quick review of year-to-date 2012 market action:

- Trading volume is anemic (YTD daily average is only 750 million shares, about 30% lower than previous years).
- Market breadth is weak (the percentage of stocks above their 10-day SMA and the number of 52-week highs is not keeping up with rising prices).
- Sentiment is heating up
- The market is shrugging off bad news
- Momentum is strong
- Apple (NasdaqGS: AAPL) is experiencing the most dramatic price spike in recent history. AAPL accounts for 17% of the Nasdaq-100 (Nasdaq: QQQ) and is this driving up the entire tech sector.

Isn’t that exactly what we saw in early 2011? What happened once momentum was broken?

The ETF Profit Strategy Newsletter identifies the target level for this rally along with an easy and to-the-point short, mid and long-term forecast and low-risk, high probability trade setups.