This is how tops break and why(ZT)

Wednesday, July 25, 2007
Just One Note On The Market's Action......
The bulls will obviously point to Apple's afterhours action, and Amazon's yesterday, as "proof" that The Bull is Alive And Well.

Oh really?

Let me point something out to you guys today. On a day where the Nasdaq NDX (Big cap Nasdaq 100) was up 1/2%, 10.59 points, declining issues beat advancers by 45:55.

On the S&P, which gained 0.47% today, once again advancers lost to decliners, 239:246.

This sort of price action is totally normal as a market tops.

Why?

Let's think about what happens during a top.

A healthy market rises more-or-less in synchronicity. There are leading sectors for sure, but there are no serious downstrokers. No really ugly surprises.

But when a market begins to top, this dynamic changes. There are one or more groups which start to not just lag but take actual, significant losses. For example today, Home Builders and Mortgage Lenders. Money rotates out of those sectors and into ones that are still rising.

This causes those sectors to fall more, and the others to rise. All things being equal, this would be market index neutral.

But its not!

People see the "winning" sectors go up and pile in; the index rises further.

But as the "brain drain" continues, breadth contracts. The rate of increase in the "chosen few" is forced ever higher - that is, the rate of change increases.

It must in order to sustain the index number increases.

Think about it guys. You have 100 stocks in the Nasdaq 100 (NDX). If 10 of them are causing all the price rise, each must go much further in order to keep the index going up - especially if other parts of the index go down!

As this rotation continues you start to see stupidity like we saw with Amazon - or RIMM last quarter - occur more and more. Companies cramming the channel and being rewarded with 20% stock price gains. Companies trading with a P/E of over 100 and a 4% net margin getting a 25% gain on earnings. Companies that disappoint on expected shipments of a new product get a nearly $15 pop, as Apple did tonight.

Why?

Because there is nowhere else to go! These are the only stocks still going up, so anything that can be spun good becomes a "safe haven" compared to the other stocks that are actually losing money.

But what comes next?

Someone who bought 10,000 shares of Apple at $150 in the aftermarket this evening wakes up at 3:00 AM. Maybe not today, but perhaps next week - or next month. He wonders to himself - "You know, that iPhone - Apple wouldn't tell us how much AT&T is paying them in commission, wouldn't give us a lot of color on things, and pretty much said they're not going to drop prices...... hmmmm..."

The next morning he wanders over to his terminal and looks for something else to buy - to rotate into. As he searches, he starts to sweat. See, there really isn't anywhere else to go with the money! AMZN? Crazy P/E. RIMM? I thought Apple was going to kill them - and they have a crazy P/E! Google? They're spending too much.....

This is how tops break and why, once they do, it is extremely violent to the downside. There simply is nowhere to rotate into that makes any sense any more! The rush to the exits begins!

So - for those of you who are sitting there tonight wondering how a company that does indeed beat the street, but says they had shipments well below consensus of the product that has been responsible for a full double in their stock price in the last few months gets a $15 pop on that announcement..... now you know.

And you also know what to watch out for - perhaps not tomorrow, or the next day - but sure as the sun rises in the east and sets in the west, when breadth contracts and market representation narrows, you better make damn sure you peek down that tunnel before sauntering in, and listen carefully to see if the rails are singing.

If you wait until you see the light and hear the noise - its too late.