5 Signs of a Stock Market Top

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Despite a rough start to the week, the long-term trend of the market is up, and always has been, according to the century-plus chart on my wall.

But in that long-term trend are periods of bull-market strength—like 2017—and periods of bear-market weakness—like the very difficult stretch we had in the last three months of 2018.

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.

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.

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At Cabot, we have two ways to measure breadth.

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 – and the number was well north of that in late 2018 and early this year.

And right now, we’ve just entered the danger zone: 41 NYSE stocks sit at 52-week lows. That’s a red flag.

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. Today we certainly have that, with record-low unemployment and U.S. GDP growing 3.2% in the first quarter of 2019. Also, 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 Wall Street’s Best Investments.

But when you’ve been in the business as long as I have, you tend to recognize one particular sign of increasingly 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!

By my judgment, we’re not there now – not four months removed from the worst market correction in years.

Stock Market Top Sign #3: Increasing Love for Popular Stocks

In every bull market, there are popular stocks that everyone wants to own.

Well, these days the so-called FANGs – Facebook (FB), Amazon (AMZN), Netflix (NFLX), Google (GOOG) – are among the most popular stocks, and they were among the weakest performers during the Q4 market decline, each falling at least 30%. Despite rebounds in all four stocks through the first four-plus months of 2019, affection for the FANGs and other market leaders isn’t overdone. Thus, it’s not indicative 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.

After turning very bearish late last year, Cabot Tides is back to being bullish, as all five indexes are above their moving averages – though a few more down days could change that.

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.

The Cabot Trend Lines is bullish today.

Conclusion

After it had seemingly evaporated in the last three months of 2018, the bull market was back in full swing through the first four months of 2018. But the rally is starting to fade, as the number of NYSE stocks at 52-week lows has reached danger territory, and Cabot Tides is getting close to flashing a bear signal. We haven’t definitively reached a market top yet, but we could be getting close. Bottom line: the market has reached a critical crossroads. And the next couple weeks could determine which way it goes from here.

Note: If you’d like 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

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*This post was first published in 2017 and is periodically updated to reflect current market conditions.

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