The long-term trend of the market is up, and always has been, according to the century-plus chart on my wall. Looking for signs of a stock market top from the thousand-foot level would be difficult.
But within that long-term uptrend are periods of bull-market strength—like 2017—and periods of bear-market weakness—like the very difficult stretch that occurred during the height of the pandemic.
If you can avoid those punishing bear markets, ideally, by selling your riskiest stocks and raising cash soon after the market tops, your results can beat the averages—easily.
The current stock market is creating huge opportunities to invest - even during a pandemic. And unless you majored in finance or are a stock broker yourself, you may not feel confident enough to start investing on your own.
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But how do you identify a stock market top?
There’s no perfect system; if there were, everyone would use it. But over the decades, we at Cabot have evolved a dependable set of criteria that’s been a big factor in helping us steer our readers to safety when risk grows.
In this column, I discuss five signs of a stock market top, starting with those signs that generally come first and ending with the one that usually comes last. Equally important, for each indicator, I tell you where we are now.
Stock Market Top Sign #1: Narrowing Market Breadth
The healthiest market is one in which the majority of stocks are participating. But as bull markets age, participation tends to narrow, as lower quality stocks are left behind and investors increasingly focus on the highest quality performers.
At Cabot, we have two ways to measure breadth when looking for a stock market top.
The first is the Advance-Decline Line, which is simply a running daily total of the number of stocks on the NYSE that advance less the number of stocks that decline. In a healthy bull market, the Advance-Decline Line regularly hits new highs. But as the bull market ages, the A-D Line fails to keep up with the leading averages. That’s called a divergence—and we don’t see it in the A-D Line today.
The second way we measure breadth—and this is only relevant to picking market tops—is to monitor the number of stocks on the NYSE hitting new lows. When the number is greater than 40 while the major indexes are rising to new peaks, it’s a danger sign. Right now, we’re in decent shape, with the number of NYSE stocks hitting new lows at 40.
Stock Market Top Sign #2: Increased Bullishness
Because the market tends to lead the economy, the economy tends to be healthier in an older bull market.
A mature bull market is one in which most investors have profits, and thus it makes sense that they feel more optimistic as the bull market progresses. One way to measure bullishness is to count the number of bulls and bears among professional and amateur investors, and Nancy Zambell does a fine job of this in our Wall Street’s Best Digest newsletter.
But when you’ve been in the business as long as I have, you tend to recognize one particular sign of increasing bullishness, and it’s the one called Fear of Missing Out, or FOMO. In short, in mature bull markets, investors no longer fear losing money; instead, they fear that if they don’t buy an investment, they will miss out on a gain! They confuse lost opportunity with lost money.
While FOMO was definitely present in 2020 and for the first half of last year, it seems to have died down a bit as trading volume has dipped and stocks have been in a bit of a holding pattern the last few weeks.
Stock Market Top Sign #3: Increasing Love For Popular Stocks
In every bull market, there are popular stocks that everyone wants to own.
In recent years, the so-called FAANGs – Meta (Facebook) (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), Google (Alphabet) (GOOG) – were among the most popular, but they contributed only 2.7% to equity returns last year as compared to roughly 20% in 2020. I don’t see any other stocks that have risen to replace them in investors’ hearts.
Conclusion: there’s not enough love for popular stocks today to warn of a market top.
Note: The first three indicators above tend to precede market tops. The next two below are trend-following indicators.
Stock Market Top Sign #4: Cabot Tides
Cabot Tides is made up of five different major market indexes that help us determine the overall intermediate-term direction of the stock market. They are: S&P 500, NYSE Composite, Nasdaq Composite, S&P 600 SmallCap and the S&P MidCap 400.
The market is considered to be advancing on an intermediate-term basis if at least three of these five indexes are advancing. Contrarily, the market is deemed to be declining if at least three of these five are declining.
To derive intermediate-term signals, we compare each index to its own 25-day and 50-day moving averages. If the index is above the lower of these two moving averages, and that lower moving average is itself advancing, then the index is bullish. Otherwise, the intermediate-term trend for the index is bearish.
Right now, our Cabot Tides are bullish, with the big-cap indexes (Nasdaq, NYSE, S&P) acting well but the others not having gone anywhere in months. We’ll keep an eye on this.
Stock Market Top Sign #5: Cabot Trend Lines
The Cabot Trend Lines monitors the 35-week moving averages of both the S&P 500 and the Nasdaq Composite to determine the long-term trend of the market.
If both indexes close two straight weeks above their respective 35-week lines, the indicator is positive; if both close two straight weeks below them, the indicator is negative. This indicator is generally the last of the five indicators to speak, and when it does, you should pay attention.
Right now, the Cabot Trend Lines is clearly bullish
Conclusion About Identifying A Stock Market Top
The last real market top occurred just before the pandemic hit, when stocks lost roughly a third of their value in just five weeks. But despite a pandemic, that bottom was followed by a sharp rebound. And while that rebound has now lasted 18 months, the five indicators above suggest we are not approaching a stock market top just yet.
Note: If you’d like our help identifying a stock market top, through regular updates on our top market timing indicators, you can get them each week in Mike Cintolo’s Cabot Growth Investor, which has used them to outperform the market by 70% over the past decade.
To learn more, click here.
Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More
*This post was first published in 2017 and is periodically updated to reflect current market conditions.