A “blow-off top,” a fascinating financial phenomenon, occurs when an individual stock or broad-market index spurts higher accompanied by increased volatility and volume, and then makes a sharp fall. Although blow-off tops occur frequently with individual stocks, they are relatively rare for indexes such as the Dow Jones Industrial Average DJIA, -0.96% and the S&P 500 SPX, -0.86% .
The rapid rise is so extreme, it will catch most investors off-guard. It’s common for latecomers to jump in with buy orders at the top. Wise investors who recognize these exceptional moves will not celebrate, but be cautious.
Looking for clues of a blow-off top
Although predicting when a blow-off top may occur is nearly impossible, you can be on the lookout for clues. Most important for investors, take steps to protect yourself before one occurs. Anyone invested in individual stocks may experience a blow-off top at some point. Unfortunately, it’s not always easy to differentiate between an unhealthy blow-off top or just a strong uptrend. Here are two situations to watch out for:
1. Excitement about a particular stock or index: Moreover, people who’ve never invested in the stock market before are buying. Plus, many financial pundits deny the possibility of a blow-off top and recommend that you keep buying. Typically, it’s only in hindsight that people realize it was truly a blow-off top and not just a strong rally.
2. The ‘high-five effect’: Here, investors make so much money in a short period, they are giving high-fives to each other . That’s a strong signal we are near a top. In addition, those who missed out on the ride higher are extremely eager to buy in at any price, even if a stock or index is ridiculously overbought.
The bitcoin blow-off top
One of the most dramatic examples of this pattern was the rapid rise in bitcoin BTCUSD, -0.63% in 2017. Early that year, bitcoin traded between $800 and $1,000 per coin, but moved higher during the year. In October 2017, bitcoin topped $5,000 per coin. Then it spiked from $8,000 per coin in November to $19,783 in December, a 1,824% return in less than a year. Exuberant investors reveled in how much paper money they had made, while those left out wanted to know how to buy. The sudden speculative interest in bitcoin was a clue this was too good to last.
After bitcoin peaked in December (the top of the blow-off), some talking heads predicted bitcoin would double again to $40,000. Some even predicted $100,000. Others in the financial media claimed the electrifying rally was normal. Days after the all-time high, bitcoin prices stalled, unable to attract more buyers. Without warning, this popular cryptocurrency collapsed. As bitcoin started to fall, there was a rush for the exit. Bitcoin fell to $6,200 in February 2018, and almost two years later, it rests near $7,000 per coin.
Here are some actions you can take before there is a confirmed blow-off top:
- If you have a properly diversified portfolio with a mixture of stocks, bonds, fixed income, precious metals, and some cash, you probably won’t lose sleep over a blow-off top in the major indexes. But if a stock you own exhibits signs of this phenomenon, it would not be wrong to slowly take some money off the table on the way up. After all, you don’t want to be forced into selling on the way down.
- Warning: Timing a blow-off top is nearly impossible, so the chances are good you may sell too early, or too late. Again, as long as you are properly diversified, even if you get the timing wrong, it will only dent your portfolio, not demolish it.
- If you have a financial adviser, it’s a good idea to discuss market aberrations with him or her. Blow-off tops are abnormal. This is the time to review asset allocation and diversification. If you are a self-directed investor, you can evaluate what you own and whether you need to sell a portion. This is not the time to listen to emotional pundits who are either warning of a crash or predicting the best is yet to come. Instead, listen to or read research reports from unbiased financial analysts. My go-to sources include money manager Lance Roberts (realinvestmentadvice.com), and economic reports from Wolf Richter (wolfstreet.com).
- Most importantly, before a blow-off top develops, review your financial plan. You can always change allocations if needed. The key to success in the market is risk management, so writing down the steps you’ll take in advance is proper preparation.
- If you are certain there is a blow-off top, you can increase cash by selling equities. The key is not to sell based on emotion but from a well-thought out plan. You should be able to recognize if one of your holdings has moved up too fast and too far. In that case, selling is a prudent move. If you have an adviser, this is a good time to discuss why you think it’s an appropriate time to sell.
- Although you don’t want to rely on emotions when making investment decisions, if you are feeling euphoria as one of your stocks spikes higher, you should objectively analyze if the profits you are making are too good to be true, or based on sound fundamental analysis.
- Consider reducing shares if a stock or index becomes overbought. One way to identify an overbought condition is by looking at the relative strength index (RSI) on a chart. An RSI reading of over 70 signifies the index or stock is overbought. Keep in mind that a stock or index can remain overbought for a long time period before reversing direction.
- The bottom line is that if you detect a blow-off top, it’s wise to be contrarian. That means selling into a rapidly rising market or stock, and perhaps buying when the equity plunges and levels off. Again, timing a blow-off top is extremely difficult, if not impossible, but potentially profitable if done correctly.
Capital preservation is the goal
Your primary goal in investing is to preserve capital while still generating profits without undue risk. The quicker a stock or index rises, the greater the possibility there will be a strong reversal. Although you don’t want to miss out during a stealth rally, you also don’t want to be caught on the wrong side of a dangerous blow-off top.
Michael Sincere (www.michaelsincere.com) is the author of “Understanding Options 2E” and “Understanding Stocks 2E.”