The U.S. stock market continues to be very strong as any pullback remains shallow and is quickly met by buying demand. The current uptrend has been intact now for almost two months now (since mid-December 2011) without any significant interruptions. The market is overbought and overextended but these concepts do not mean the market will pullback. So, how we can recognize that the market is close to a top or has made one?
The most important thing to watch, of course, is the price action. As long as there is a series of higher highs and higher lows on the daily and hourly charts of main stock indices, the trend is higher and should be respected. But one can derive further knowledge if they take a look at two other important factors:
1.) The trend in VIX (volatility) index. Usually VIX is trending lower as the market moves up. Then as the top approaches, VIX starts to be more volatile. For example, VIX rose sharply last week (first full trading week of February) from 16 to 21. But usually the first rise in VIX is not the time when the price trend reverses. What can we expect to see, is another decline in VIX back toward its most recent lows (near 16) and only the second or the third attempt higher will be accompanied by a trend reversal in stock prices. You can see the dynamics of VIX between May and July 2011 for guidance of what we can expect here.
2.) The second thing to watch is the stock participation in the rally as it nears its end. As the rally exhausts itself, it is logical to expect fewer and fewer stocks and sectors to participate in it. So, it is important to pay attention every week to the trend in some major stocks and major industry ETFs (or even international country ETFs) for clues. Once you start to see more stocks and ETFs as short sale candidates as the main indexes advance, it means the rally is in its late stages.
Going to the current market, I start to see some signs of weakening but a top is not there yet. I think we need to see at least one more fall in VIX before a top can be made. And sure enough, the market should become internally weak (i.e. less and less stocks to participated in the advance) before the trend can reverse.