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Write it down. Engrave it in stone, or at least into the wall. ĎSurrounding conditions always look great at market tops!í

 My mail has been particularly heavy in recent weeks, mostly along the lines of ďHow can you possibly be bearish on the stock market and expecting a sharp decline to a low in October? Is your head in the sand? Donít you see how strong the economy is, how strong corporate earnings are? Donít you realize how tame inflation is, how confidently consumers are spending?Ē

Sure I do. I hear it every day from Wall Street.

The problem is that not much of the current bullish case has anything at all to do with what is actually bullish (or bearish) for the stock market at its tops and bottoms.

I devoted half of my 1999 book Riding the Bear Ė How to Prosper in the Coming Bear Market, to pointing out that if investors are to break the historical pattern of being excited and buying heavily at market tops, and depressed and selling out at market lows, they need to at least learn the most basic attribute of the market; that conditions at market tops always look great, and at market bottoms always look horrible.

After the economy and stock market have been in a serious decline for awhile, obviously  conditions become increasingly dismal, with the economy slowing, corporate earnings in decline, and consumers more and more pessimistic. By the time the market reaches its ultimate low, and is ready to begin its next big rally or bull market, those conditions are at an extreme of bleakness. Think recession, woeful corporate earnings, dismal forecasts by analysts and corporate managements, low consumer confidence and spending, demoralized investors. Those will always be the conditions at stock market lows.

However, after that low is in, the economy and the stock market begin to rise again, often prodded along by a friendly Federal Reserve cutting interest rates, and increased federal spending to get the economy stimulated again. The early stage at the bottom is also the denial stage for public investors. No way could a new bull market begin with such dismal surrounding conditions. Those who are buying, primarily insiders and institutions, are wrong. The market will soon reverse to the downside again, and hit even lower lows.

But as the economy and stock market continue to rise, more investors begin to lose some of their fear and dip their toes in, and the rally and new bull market continue. It is during this period that news of stronger economic conditions and rising corporate earnings are meaningful. Stocks are still undervalued. Investors are still too pessimistic. Technically, the market still has a long way to go before it will become overbought.

But eventually, the bull market runs its course. (The average bull market lasts about three years, the unusual bull markets of the 1920s and 1990s being the exceptions). Stocks become too highly priced. The economy has been strong long enough to create extreme conditions, perhaps an unreasonable bubble in investment prices, excessive risk-taking and speculation, high debt levels, high energy costs. Perhaps conditions have even become so strong that the Federal Reserve is concerned, and has begun to raise interest rates to cool things off.

At that point in the cycle, continuing strength in economic numbers and corporate earnings are meaningless. They are just part of the great surrounding conditions at market tops. Donít try to tell me why this time is different. Iíve heard it all before, in 1987, in 1989, in 2000. The history is clear.

The fact is that the stock market always tops out before the surrounding conditions turn sour. The most recent example was the way the Dow topped out in January of 2000, but the economy and corporate earnings remained so strong that the Federal Reserve was still raising interest rates four months later in May of 2000, in its efforts to get the economy cooled down.

Yet, once extreme conditions that indicate a top are in place, be they bubbles in an investment area, high consumer debt, insider selling, extremes of investor bullishness, overbought stock prices, unfavorable seasonality, or whatever, it still takes a catalyst to actually top the market out.

The two most common historically, have been rising interest rates, and rising energy costs.

Rising interest rates have topped out more markets than any other single factor. Why? Because rising interest rates are a sure sign of an economy that has gone so far it has created excesses that have even the Federal Reserve concerned and raising rates in an effort to get things cooled off. (The Fed has now raised rates ten times since June of last year, and interestingly enough, strong earnings and economic numbers or not, the market has gone nowhere since. It has been in a very narrow trading range, in which, even with the Dow again near the top of the range, it is still only 1% higher than its level of June, 2004). In spite of all the euphoria among public investors, someone has already been selling heavily enough to offset their buying.

The second historical market-topping catalyst has been high energy costs. There has never been a time when sharply rising oil prices did not eventually top out the economy, corporate earnings, and the stock market. Donít tell me the bullís story that obviously the market doesnít mind high oil prices this time, since it hasnít topped out - yet. Or has it?

But above all, donít tell me the market wonít top out because the economy and earnings remain strong. That is not how the market works. It tops out before the economy, before earnings, and while conditions have consumers confident and investors optimistic that this time will be different. 
Sy Harding

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