At first glance, fool's gold cannot be distinguished from real gold. Even upon examination, novices are not able to discern the difference. To avoid getting fooled, miners have come up with the acid test.
Most metals tend to bubble or fizzle when they come into contact with acid, precious metals don't. Placing a small drop of a strong acid, such as nitric acid, onto the metals surface quickly and unmistakable differentiates real gold (NYSEArca: GLD - News) from fool's gold.
Is there a time-tested method to distinguish a bull market from a 'fools market?' Is the market 'bubbling' right now (two-fold meaning of bubbling intended)?
A thorough acid test for stocks (NYSEArca: VTI - News) involves a short-term and long-term analysis from multiple angles. Sentiment indicators, technical indicators, fundamental data, and valuations should be taken into account.
Volume and Conviction
Discernment of trading volume is one of the most basic components of technical analysis. High trading volume shows conviction, while low trading volume indicates lack of conviction. Trading volume is not a short-term indicator, that's why we look at longer-term time frames.
The chart below reflects the analysis of the NYSE trading volume over three time-frames.
1) The October 2007 - March 2009 decline
2) The March 2009 - April 2010 rally
3) The post April 26, 2010 decline
The daily NYSE trading volume from the October 2007 highs to the March 2009 lows averaged 1.48 billion shares. The daily trading volume from the March 2009 lows to the April 2010 highs average only 1.30 billion shares, a 12.63% drop. The trading volume since the April 26 peak averaged 1.59 billion shares, a 23% increase.
What's the essence of this analysis? Conviction associated with the March 2009 - April 2010 rally was limited compared to the declines that sandwiched the rally. According to trading volume, the March 2009 - April 2010 rally was a counter trend or sucker rally.
If we drill a bit deeper, we see a large number of distribution days occurring since the April highs. Distribution days see the major indexes decline on large volume. Not only that, the rally that lifted the S&P (NYSEArca: SPY - News), Dow Jones (NYSEArca: DIA - News) and Nasdaq (Nasdaq: QQQQ - News) some 7% over the past two weeks has come on the lowest volume in nearly two months (see chart below).
The conclusion we may draw is that not only has the larger trend turned down, the recent rally seems to be fizzling out as well.
Wall of Worry
It is often said that new bull markets climb a 'wall of worry.' The 'wall of worry' is a broad description and can easily be misunderstood. We'll clear up some of the confusion here and highlight how you can measure 'worry.'
Bear markets go through three stages. The third and last stage of a bear market - or one leg within a larger bear market - is the 'throw in the towel' stage. In this stage investors are worn out by the bears shenanigans. Either they get tired of waiting for 'just one more rally' that doesn't show up, or looking at ever falling portfolio balances.
Either way, investors do what they should have done a long time ago, they sell. Initially, phase 3 tends to drive down prices even further. It can also be considered the capitulation phase. Generally, the market bottoms shortly after most investors capitulate and throw in the towel.
We saw phase 3 play out in February/March 2009. From 9,000 in January, the Dow tumbled to 6,500 in March. During that phase, investors capitulated. This drove price significantly lower, but (and that's a bit but), it also established a bottom.
When most investors were capitulating, the ETF Profit Strategy Newsletter recommended selling previously recommended short ETFs and load up and long and leveraged long ETFs via the March 2, 2009, Trend Change Alert.
It is important to note that the 'throw in the towel' phase lingers around during the initial portion of the recovery where investors refuse to accept that a low is in place. This spillover from the 'throw in the towel' phase IS NOT the 'wall of worry.'
If there were a 'wall of worry' it would persist throughout the rally. As the chart below shows, however, investors became more and more comfortable with the idea of risking prices as stocks rallied.
By May 2010, 56% of investment advisors tracked by Investors Intelligence were outright bullish, the highest reading since December 2007. A few weeks earlier, the CBOE Volatility Index (Chicago Options: ^VIX) had fallen to the lowest level since July 2007.
Based on these and other extremes and the apparent absence of a 'wall of worry,' the ETF Profit Strategy Newsletter noted on April 16 that 'historically, there has rarely been a more pronounced sell signal.'
From the extreme pessimism seen at the March 2009 bottom, the market (NYSEArca: TMW - News) rallied on extreme optimism. Extreme optimism, particularly amidst deterioration of fundaments, is usually associated with a major top.
Valuations
Less is more. Ivy League Wall Street gurus prefer to use high-tech simulation models to predict the market's futures. Truth be told, none of those high tech tools saw the 2000 tech crash (NYSEArca: XLK - News), 2005 real estate crash (NYSEArca: IYR - News) or 2007 financial crash (NYSEArca: XLF - News) coming.
Three simple valuation measures, however, did. Valuation measures are not short-term timing tools, but they allow you to see the market's short-term behavior in the long-term context. Sooner or later, stocks always revert to their mean.
Any asset class may remain over or under-valued for a while, but eventually it will revert to fair valuations. That's simply how it is.
Based on P/E ratios, dividend yields and the Dow measured in gold (NYSEArca: IAU - News), stocks were overvalued by a large margin already in March 2009 and particularly in the beginning of 2010.
Over the past six months we saw P/E ratios spike to an all-time high, while dividend yields and the Gold Dow challenged their all-time lows.
Market bottoms are made of the exact opposite - rock-bottom P/E ratios, sky-high dividend yields and a Gold Dow that's rising, not plummeting.
After examining technical evidence, sentiment indicators and various valuation metrics, it becomes obvious that the recent bounce provides a selling, not buying opportunity.
In fact, the July ETF Profit Strategy Newsletter featured the one chart pattern that highlights just how steep the next leg of the decline could be. Each issue of the newsletter includes a short, mid and long-term outlook for the major asset classes, along with a detailed analysis of the above- mentioned 'red flags' and corresponding profit strategies.
Remember, sucker rallies - just as fool's gold - appear to be real, but they're not. Use the modern day acid test and protect your portfolio.
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