How to combat market 'froth'

One thing all great stock market bull runs have in common: they make people giddy. Yet investors must be able to spot when the market's a bit too 'frothy' - and get out.

There's one common denominator that shows up in most great stock market bull runs: They make everyone giddy.

When the market is roaring along - as it is now - the talking heads on television have an excited tone to their voice. Brokerage firms run more ads because people want to put more money into the market when assets are rising. And average investors finally stop procrastinating and pull the trigger so they don't miss out on 'the rest of the big move.'

Don't be one of these 'average' folks who follows everyone else like a sheep, and jumps blindly in at the height the froth.

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Yes, the markets are exciting right now. Yes, you can't turn around without the Dow hitting a new all-time high. But no... you shouldn't be piling in now for fear of missing all the excitement and the promise of gains.

There are better ways to play this market right now. Let's look at some of the telltale 'froth signs' and see how prudent investors should combat the current situation.

Stock market bull run: four signs of of a frothy climate

#1: Dangerously Fast Dow: Through Monday (May 7), the Dow Jones Industrial Average had risen in 24 out of the past 27 trading sessions. The market has not powered up consistently like that since July-August 1927. While this looks like a very strong market to some, there is a warning sign here that you must heed. The markets are a complex mix of give-and-take. Nature, it is said, abhors a vacuum. And markets abhor one-way streets.

#2: Tight Trading Range On S&P 500: Monday also marked the lowest trading range day that we've seen in the last five years. The S&P Futures had a range of just 3.75 - a number so low that it's only happened twice before in the last five years (July 2004 and November 2006). Low volatility is always a sign of market indecision. Right now, the market has two big central bank announcements to deal with this week - the U.S. Federal Reserve and the European Central Bank. Both will let the world know their rate policies in the next couple of days. And this basically has the market holding its breath and waiting to exhale.

#3: China Concerned About Market Froth: Top-level banking officials in China are concerned about the frothy state of the market. Deeply concerned. As renowned analyst Dennis Gartman reported in his letter on Monday:

'Mr. Zhou Xiaochuan, the Governor of the People's Bank of China, is in Basel, Switzerland, for a meeting of the Bank for International Settlements. The press assembled there is hovering on every statement that Mr. Zhou has to make. One has our interest here, for Zhou said that he is indeed worried about what seems to him to be a 'bubble' in China's stock market. He said that the Bank is 'monitoring' the market on a regular basis. Mr. Zhou is not given to wayward comments, and he knows how seriously the world shall take his use of the term 'Bubble.' Mr. Zhou is not naive. He is a seasoned operator on the international scene, and we suspect he used the term 'Bubble' only after careful consideration. He knows that all bubbles end in tears. But he, like we, has no idea when the bubble shall burst. He knows only that it shall.'

#4: Goldman Sachs Momentum Looking Weaker: Stock market bellwether Goldman Sachs is showing momentum divergence. This means that while the stock is making new highs, it's doing so with less 'push' and less strength than the previous highs. I've illustrated this in the 'Chart of the Week' section below.

Stock market bull run: what's an investor to do?

When the market is showing these key signs of 'frothiness,' the bottom line is this: Don't jump in with both feet.

If you're fully invested, by all means keep riding the wave. Just make sure that as you do, you have your stop-losses in place, and keep adjusting them as long as the market keeps moving in your direction.

If you have money to invest, the most prudent decision is to hold some of it back until the market has had a chance to relieve its overbought condition.

But be aware that frothy markets can have blow-off tops that have rapid gains before any correction comes into play. And a Fed announcement is the type of trigger event that can cause a blow-off top, or kick the market over the edge toward corrective activity.

By D.R. Barton for the Smart Options Report,