When Will The Stock Market Top?

The classic definition of a blow-off top in the stock market is a sharp rise in price and volume that precedes a fast price decline on high volume.

With the S&P 500 up 23.3% year-to-date and the NASDAQ rising by 42.7%, one market analyst has made it clear that he believes a climax top is on the verge of occurring. If so, how do you trade it?

Stock Market Blow-off Top

The current market conditions are highly unusual. At the end of October, the S&P 500 had risen by approximately 10% for the year. Then a ferocious rally ensued, and it was largely a function of seasonality.

Specifically, one market analyst, Cem Karsan, has astutely described opposing forces in the market as seasonal flows versus macro flows. 

As the year-end approaches, you can think simply of macro flows as bearish forces and seasonal flows as positive. The reason macro flows are considered as dragging the stock market lower are numerous but one simple example is to think about bond yields offering an alternative to equity investors now.

With 3-month Treasury bills paying over 5% annually, many investors who had previously invested capital in equity markets during the past decade when yields were closer to 0%, could predictably and safely lock in a fixed return, leading to an outflow of capital from equity positions.

Seasonal flows we have discussed previously when explaining the reasons for the Santa Claus rally but, in brief, they boil down to recollateralization, options effects, and volume-weighted time.

The most important of those is recollateralization, meaning when markets go up substantially the net effect is for investors to increase leverage in order to keep their risk levels similar, and so new capital is invested.

To further boil that down to an individual use-case, though admittedly it is much more pronounced for institutional investors and hedge funds, imagine a single person has $100,000 of cash in their portfolio. With this sum, they can actually invest $200,000 into stocks by tapping into margin.

If they bought $100,000 of an S&P 500 exchange-traded fund on November 1 and it rose by approximately 15% through December 15, as it did this year, the account would be up to $115,000 but now the trader can buy an additional $115,000 in stocks using margin.

In that short period, a real equity gain of $15,000 has occurred plus an additional $15,000 can be dipped into, for a total of $30,000.

Now multiply this newly created capital across all the money managers, institutional and otherwise, and you end up with an enormous need to recollateralize.

The net effect is for gains to beget further gains, and higher prices to lead to even higher prices. As more money is deployed into the system, shorts get squeezed also, further driving prices higher. And then there are those who attempt to front-run the bullish rally, creating even more demand.

So what happens, volume rises and price rises too, and it all culminates in a blow-off top. But when will the market peak?

When Will The Stock Market Top?

With ballooning debt, the Treasury is issuing massive amounts of paper that is pulling liquidity out of the system. Those bearish forces will continue but, for now, they are being more than counteracted by the bullish seasonal flows described above.

Critically, the seasonal flows are transient while the paper issuance (aka negative flows) will remain after the holiday bullishness is in the rearview mirror.

So when will the stock market top? On January 17, 2024, the stock market is forecast to top according to analyst Cem Karsan as bullish seasonal flows give way to bearish macro flows.

Between now and then the Santa Claus rally is forecast to support higher prices. And as the new year kicks off, the January Effect comes into play and amplifies the bullishness.

On January 17, VIXperation will occur, a couple of days before one of the biggest equity options expirations of the year. From that date forward, particularly entering February, expect market weakness to dominate as macro flows take precedence again.

Keep in mind, it was only in October when widespread concern was abound of war, inflation, and soaring national debt and interest payments.

Often narrative follows price, and when the market was falling those talking points made headlines. As the market rallied, they faded into the background, but expect them to re-surface in Q1 2024.

How The Options Tail Wags The Equity Dog

One very notable trend that investors should pay close attention to is how the tail of the options market wags the equity dog, meaning options flows (vanna and charm effects) can impact equity prices.

To exemplify this, look back no further than 2020 when word that a contagious virus was spreading. In spite of the media headlines, it took about two months before the market finally turned down in a very sharp way during the months of February and March.

Notably, the March 2020 stock market bottom precisely overlapped with March options expiration. So, even though bearish news was spreading in December and January, the bullish flows dominated and the market managed to climb higher until finally, after dissipating, the bearish forces and fundamental drivers returned with a vengeance. And crucially, they ended right when the options expiration would have predicted.

So, how do you play the next few months? If the past echoes the future, the next week or so from December 15th to 22nd will be a period when bullish forces subside, post December options-expiration. Thereafter, expect another bull run into end of year and a continuing upsurge in the market until January 17, 2024.

This date is a line in the sand but somewhere in the week before or two weeks after, expect the market to hit a top, climax on high volume and price, and then fall sharply, also on elevated volume, heading into February.

Once you learn the seasonal flows you can better position your portfolio by understanding the forces of supply and demand. Of course, if you want to see how your individual stocks are likely to perform seasonally, join us here.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.