Most of the time, people tend to trust their perception about the markets. However, I’ve learned to never ask myself, “What do I think?” as it concerns the markets.

Instead, I trust measurable metrics such as fundamentals, technicals and sentiment. I like things that are defined and that I can put my finger on. Really, any good professional uses definable metrics. Aren’t you glad your pilot doesn’t just “go with his gut” when he’s flying you to your destination? Also, have you ever ridden with someone who acts like they know where they’re driving to and you know they’re lost but they won’t pull out a GPS? Using things that can be measured/defined help us to not have to go off of hunches, gut feels or anything that we perceive. I’ve found that those unmeasurable “feelings” will be way off base near market tops and bottoms.

But how do you know when the market is nearing a top? Well, there are metrics that we can use to gauge when we’re at risk of a top. For instance, we can track the historical average P/E (price-to-earnings ratio) of the S&P 500. Right now, that average P/E is at 25! In short, we’ve had market crashes once the price of the index got that far stretched from its average earnings.

Another way we can tell when we’re getting near a market top is by looking into Elliott Wave analysis. Elliott Wave Theory says the market goes up in five major waves (1-2-3-4-5) and corrects in three major waves (a-b-c). There are rules to each of these waves which I won’t go into here. But if you want to learn more about that, you can watch my video on the topic:

In the chart below, you’ll see I’ve labeled all five waves plus the end of wave C (which is the correction’s bottom). Notice that anytime we’re well into wave 5, we’re pressing our luck as far as upside gains and we’ve got HUGE downside risks.

Additionally, when wave 5 is nearing its end, we’ll see divergences typically form in the RSI or MACD indicators. This is where the indicator goes flat or slumps lower while the market is still rallying higher. It shows that the market is likely losing its upward momentum and that a change is likely coming, to the downside. I’ve emphasized those with the red slanted lines in the chart above.

Notice that the downturns were so harsh, percentage wise that even if you got out of the market a couple of years early before the market actually topped, that you’d have been glad you did because these declines in 1987, 2000, 2008, etc were at least 36% to around 60% corrections/crashes.

Yet had you exited early like that and seen the market continue to climb, your perception would be that you screwed up and that you “missed out”. However, ask anyone that rode the market all the way down (or most of the way down) and they would have loved to have switched places with your “early exit”.

I write all of this to you now because we’re well into wave 5 once again. We don’t know if we’re at the end yet BUT we do know that the risks are extremely high now due to the average P/E of 25, due to the market being well into wave 5, due to indicators diverging and due to the price of the index being so far stretched away/above its 200-week moving average.

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