The Fundamentals of Market Tops

Here are ways that corporate behaviors change near a market top:

The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can't find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.

Other Gauges

These two factors are more macro than the investor base or corporate behavior but are just as important.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback.