When euphoria is gripping the markets it can be hard to stand back from the frenzy and see that things may be heading for a reversal. This is why vigilant investors must dismiss emotions and remain focused on what the market is saying. A rising market will eventually correct and there are often early warning signs before the fall occurs. An investor who is aware of these signs can take profits in a rising market and then be on the sidelines for the correction, waiting patiently for prices to rise again.
Can We Predict Market Tops?
Markets are dynamic and as such, the chance of picking an exact top (or bottom) is unlikely and also not required in order to profit from the markets. Capturing the bulk of a trending move will provide substantial reward; therefore, there's no need to try to squeeze out every penny. Such attempts will likely result in the trader hanging on for too long, and then giving up profits when panic selling kicks in.
While searching for exact market tops will prove to be a failed endeavor, there are signs that indicate a correction is coming. Knowing that we will not be able to pinpoint the exact top (whether it be price or time) a trader can take profits when the market begins to show signs of weakness. Even if the market continues to rise for a time, they can take comfort in knowing the signs of correction were there, and that exiting was the prudent thing to do. (For background reading, see Which Direction Is The Market Heading?)
What to Consider Before Looking for a "Top"
Small or large, markets always move in waves, whether in a trend or contained within a range. Therefore, for a top to form, a rally of at least nine months must be visible. Waves may occur along the way, but the overall trend must show growth for at least nine months.
Trends can last a long time and nine months is actually a short rally by historical standards. Between 1942 and 2007, the average bull market was 56 months. The nine-month range is simply used to prevent over trading and to avoid being stopped early in a rally. A rally must be present before a top can take place and also before we can use the following market signals. (For more, see Connecting Crashes, Corrections And Capitulation.)
3 Signs of a Market Top
These market indicators will help provide insight into the underlying strength or weakness of the market. The first two signals are often present before a top is made, while the third signal acts as a timing indicator to show prices are headed lower.
The number of 52-week highs begins to decline, despite growth in indexes. If the number of 52-week highs declines, this indicates that fewer stocks are working to push the market higher.
2. The NYSE advance/decline has peaked and is now declining, even though the S&P and Dow continue higher or have stalled. This indicates that while the selective market indexes are moving higher, the broader market is struggling.
3. The major indexes move below a prior swing low. This is the ultimate confirmation of trouble. In an uptrend, prices make higher highs and higher lows. Therefore, when prices fail to make higher highs, or create a lower low than the previous low in the uptrend, the uptrend has failed. The daily or weekly chart is commonly used, but the time frame can be adjusted to reflect the individual investor's time horizon.
Ultimately, the third signal will provide our timing indicator. It is possible that while the NYSE advance/decline line and the number of 52-week highs may be decreasing, the major indexes may continue to move higher, although the number of stocks participating will be declining. Therefore, when all the signals align, this is a strong indication that the market is going to have a large correction. This can allow investors to take profits and then move to the sidelines.
Figures 1 through 3 outline how this scenario played out in the decline of 2008 to 2009. The NYSE high/low chart shows this clearly, declining well before the sell is reflected in the Dow index. The timing indicator also confirmed that price was showing signs of weakness (it broke a prior low) in the first week of 2008, along with the NYSE advance/decline line.
|Figure 1: Dow Jones Industrial Average, Weekly|
Figure 2 shows declines in advancing stocks prior to 2008.
|Figure 2: NYSE Advance Decline Line, Weekly|
Figure 3 is one of the most telling signals, as the new 52-week highs begin declining dramatically near the end of 2007.
|Figure 3: NYSE New Highs - New Lows, Weekly|
While a move below a swing low is used for the price indicator, the tactic can also be used for the trend of the NYSE advance/decline line and the number of 52-week highs. When plotted over time, a trend will also be visible with these indicators. Like price, a rising trend is indicated by higher highs and higher lows. Therefore, when the line corrects below a prior swing low, the trend for the indicator is declining.
When prices make new highs and the indicators fail to make new highs, this is called negative divergence, and it is an early sign of weakness. This weakness can last for some time, and this is why only an actual break in price can confirm the signals.
Since the market always moves in waves, not every decline is a reason to exit the market. However, when a series of signals align, it can provide evidence that the market is creating a top and could be entering a larger correction. The NYSE advance/decline line and the number of stocks making 52-week highs can provide early warning that the number of stocks participating in the market advance is declining. If these indicators fail to reach new highs (or move lower) along with the market, this may be a sign of weakness in the market. Weakness means prices will break immediately; therefore, a third signal is used: Price must move below a prior swing low. When the NYSE advance/decline line and 52-week highs have fallen and prices break below prior swing lows, the uptrend no longer exists and it is likely a further correction will be seen. (To learn more, see our Market Breadth Tutorial.)