Why A Potential "Blow Off Top" Is Good News For Traders...

With major stock market indexes at new all-time highs, it's obvious to many analysts that we are in a bull market.

The question, of course, is how much longer can it last.

To examine this, I'm including a chart of the SPDR S&P 500 ETF (NYSE: SPY) that shows the new high.

I also included the stochastics indicator at the bottom of the chart. Stochastics is a popular momentum indicator that is widely followed. I don't believe that it works well as a timing tool, but the indicator does have an important characteristic.

Let's take a look...

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In a bull market, stochastics moves to overbought extremes and stays there. Stochastics moves between values of 0 and 100. In the chart above, the value for 80 is marked with a solid horizontal line. This is generally considered to indicate an overbought extreme. This means prices moved up too far, too fast.

Overbought is often considered to be a sell signal. But the chart shows that on the weekly chart, an overbought reading in stochastics is actually a "buy" signal. You can see how the indicator moves above 80 and remains there in a strong uptrend.

The chart above tells me that we could be at the beginning of a strong move. It won't be straight up, which means there will be pullbacks along the way. But the next big move is likely to be up.

Get Ready For A "Blow Off Top"

However, the move is narrowing. Large cap stocks are the market leaders. The next chart shows that small caps remain below their all-time highs. This is a chart of the iShares Russell 2000 Index Fund (NYSE: IWM).

Ideally, small caps would lead the market higher. That's because these are the most aggressive stocks. Gains in aggressive stocks show that investors are extremely bullish. Gains in the large caps, like we see now, show some lack of conviction.

There are reasons to expect small caps to break out. Stochastics is bullish. And this is a seasonally bullish period for small cap stocks.

Years ago, there was a "January effect" in small cap stocks. Academic studies often looked at gains for the 11 months from February to December to look for statistically valid indicators. That was because January was consistently bullish and often accounted for a large part of the year's gains.

That effect became widely followed in the 1980s, and now it is less evident. But small caps are reliably bullish in the last quarter of the year. In fact, IWM shows a gain 84% of the time in the fourth quarter.

With momentum and seasonals both indicating gains are likely, it is possible small cap stocks will rally to new highs. This would most likely create additional bullish sentiment among investors and could be the catalyst for a "blow off top."

Throughout history, most bull markets end in a blow off, which is a race to new highs with prices growing faster than the fundamentals. The blow off usually comes just as a recession is beginning. Right now, we are at the point where a blow off is likely.

That's good news. We will be able to participate in the rally as it unfolds, and we will be able to remain cautious since we realize that after the blow off comes the collapse. That weekly stochastic, a simple indicator anyone can follow, will drop below 80 as the decline begins. Because of this, it is one of the indicators I am watching closely.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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