Note:  Other pages relevant to the subject of market prediction can be found here and here.  Both of these links deal with short term market-prediction (with a horizon between 1 day and 4 weeks into the future), while the discussion below deals with longer-term prediction, and the characteristics of market tops and bottoms.

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Sep 6, 2004...Here's a link to a very nice article at the Economist.  The article covers a number of bases, but the focus is on rational prediction of markets, particularly market crashes.

Since the link is likely to die in the future, I'll quote liberally from the article: 

Although standard financial-market theory assumes that it is impossible to tell anything about the future direction of a market by looking at what has happened in the past—so that markets follow a “random walk”—most investors are seeking to do just that. When both real market data and random simulations of such data are put before traders, they claim to see patterns. This is no surprise. People see patterns, where there are none, all the time—in clouds, in lotteries, in mountains on the surface of Mars, and even in root vegetables. Predicting a number in a lottery based on such a spurious pattern cannot, of course, have any effect on whether that number is actually drawn. But the same is not necessarily true of the stockmarket. When many traders think they see the same pattern, they may respond in the same way. They may thus, collectively, create a real pattern.

And not only real, but unstable. For, paradoxically, the more orderly a market appears, the less stable it is. (Think of dominoes up-ended on a table. If they are distributed at random, knocking one over causes little damage. If they are in a line, the whole lot will come down.)

Now, we haven't done any testing, but it would seem that we have excellent gauges of market "orderliness" here on our own website.  Looking at our various short, mid, and long-term data tables, it's relatively easy to see which the extent to which various trends have persisted.  One can also judge the extent to which various groups of stocks deviate from average groups.  To what extent are various groups "taking off" or "diving"?  To what extent are stocks moving in tandem?

The "feeling" I get from the current market is far from one of "orderliness".  No particular trend has been taking hold this year, except perhaps for the tendency of oils to gain (which may be a very logical response to events in the Mideast and predictions of peaking oil supply in the next 5 to 10 years).  If this feeling and the above quotes are "correct", one would assume that a market crash is certainly not imminent.

The researchers in question employed a market simulation involving computer "agents" with various tendencies.  In the real world, you've got momentum guys, bottom-fishers, fundamentalists, technicians, long term guys, day traders, conservatives, speculators, shorters,  hedgers, rationalists, the superstitious...even a smattering of seasonal investors...and more.  Some investors are more driven by fear...others by greed.  Glom them all together, with their differing and sometimes contradictory propensities, and you get the market. 

It's an interesting approach to market prediction, and we've sometimes thought in the same terms.  Problem is, the simulations would be quite complicated from a programming angle, and I'm a bit dubious about how one would arrive at "realistic" distributions of, say, fundamentalists versus technicians.  One "simplifying factor" would be my own observation that folks are normally quite religious about the investment strategies they employ...today's momentum investor will almost certainly not be tomorrow's bottom fisher.

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We took a look at the "major bottoms" of the S&P 500 index over the last 10 years and identified the following:  7/18/96, 4/10/97, 12/31/97, 10/7/98, 10/18/99, 4/4/01, 10/8/02, and 3/10/03.  The market made a quick 10%+ move upward in all these cases.  Our main criteria for selection, though, was simply the way the chart looked.

The question we asked:  what were the market conditions just before and after these turnarounds?  We rustled through our daily and bi-weekly tables (available to you, should you care to repeat the exercise yourself for the sake of verification), and came up with the following observations:  

• these bottoms had a strong tendency to be preceded by markets in which volatile stocks and cheap stocks were on losing streaks.

• the bottoms were preceded by strong relative performance in mid-term and yearlong gainers

• the bottoms were followed by reversal of the above:  gains in cheap stocks, volatile stocks, semiconductors, and yearlong and recent losers.

• looking at the charts, it does appear that strong market volume is a characteristic of the early stages of these bull runs.  That is, you couldn't use market volume to predict the bottoms, but you might be able to use it to get in on the early part of the rise.

These observations aren't particularly scientific...we didn't run through our data for "false negatives"...cases where the above conditions were met, but a strong bull market didn't manifest.

It's interesting to note that 3 of these bottoms occurred in October, though we don't want to read too much into this.

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Having done a rough search for the conditions at market bottoms, what characterizes market tops?  We looked at the following tops:  7/15/98, 7/21/99, 8/22/00, 5/22/01, 3/15/02.  It's not that we couldn't have gone back further in time, but the bull run of the early-mid 90's formed surprisingly straight curves, with few pullbacks of note. 

The conditions at these tops didn't seem quite as uniform as those for the bottoms.  The most general theme seemed to be of volatile stocks declining WITH small caps resisting losses in the early stages of the decline.  So, there's something of a schism between these two groups, which normally have a positive relationship.

Looking at the chart of the S&P 500 over these years, market volume didn't seem to be much of an indicator that the market had "topped out".

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