Calling a market top is part of an investing strategy known as market timing. Many investors claim market timing is impossible. Others routinely use different strategies to find out when a stock that has been trending upward runs up against unusually strong selling activity.
This is almost always a sign that the institutional investors are taking profits. And when traders see that happening, it’s best not to be swimming upstream.
Is the current market signaling that a top has arrived?
For all of its volatility, the net result of the market has largely been sideways over the past 12 months. The S&P 500 (SPX) has gained 2.1% over the past year. The Dow Jones Industrial Average (DJIA) is up a mere 0.8% over the same time period.
According to one market observer, gains like this would be inconsistent with a market that is ready to correct. Joseph LaVorgna, the chief economist for the Americas at Natixis writes, “Some investors have speculated that the market might be topping out ahead of a possible U.S. slowdown over the next year, says LaVorgna. “However, this would be very unusual, as equities have always had a double-digit rally before the economy experiences a downturn.”
This sentiment is echoed by widely followed economist and analyst Alex Kruger who believes that the current fear surrounding U.S. equities is unfounded. According to Kruger “the burden of proof is on bears”.
The trend is your friend
According to Kruger, there have been no clear reversal signals to indicate that the current uptrend is over. In an exclusive interview with CCN, Kruger said, “I’d say stocks topping out now is nonsense. Stocks are in a multi-year bull market. The trend is up. The all-time high is less than a couple percentage points away. It is statistically improbable for the top to be in.” Kruger concludes, “Bears have been wrong over and over and over again. Most bears have been bearish for years. Why are bears correct right now?”
Why is this important?
Economists have been falling over themselves trying to predict, or calm fears about, a recession. According to LaVorgna, the current market suggests that the U.S. business cycle is not quite ready to roll over. Investors have quite a bit to consider with the U.S. economy about to enter an election year. Not having to worry about a recession would calm one fear.
Market tops are normal
When the market is going up, investors may get overcome by the thrill of seeing their portfolio increasing in value and lose sight of their investing goals. But as LaVorgna pointed out, that’s exactly the time when investors have to be concerned about a correction.
Although I agree with the sentiment that it is virtually impossible to predict a market top, the market can give an investor warning signs, if they know what to look for. The point is not to predict the exact top, but to get out before the correction. Getting out of the market a little early (or a little late) can still net investors a generous profit.
Signs that a top is forming
The first signal that a market may be ready to correct is a sustained rally. Markets don’t move in the same direction at all times. The movement takes on a wave-like motion. For a market top to exist there must be a rally that lasts for at least nine months. Within that time frame, the market may go up and down, but investors should notice a clear upward trend. This looks like an ascending staircase with higher highs and higher lows.
Once the market has been in the uptrend for at least nine months, there are additional signals that can help investors find a top.
- The number of 52-week highs in the broader market starts to go down, despite the fact that the index is growing. Since an index is made up of a variety of stocks, a failure to reach a 52-week high is a sign that fewer stocks are pushing the market higher.
- Another sign of a market top is when the New York Stock Exchange (NYSE) advance/decline indicator is now declining. This will happen independently of what is going on with the S&P 500 or the DJIA. This is significant because it indicates a struggle in the broader market.
- An almost certain predictor of a market top is when the major indexes move below a prior swing low. Remember when a market is in an uptrend it achieves higher lows. In this case, prices are failing to reach higher highs or maintain a higher low. This means that the uptrend has now been broken.