3 Key Signs of a Market Top

When euphoria grips the markets it can be hard to step back and see that they may be heading for a reversal. Inevitably, a rising market will correct and there are often early warning signs before the fall occurs. An investor who is aware of these signs can take profits while the market is still rising and then get on the sidelines before the correction.

Can We Predict a Market Top?

The chances of picking an exact top (or bottom) in the market is unlikely in the extreme. It's also not necessary to make a profit.

Capturing the trend will provide substantial rewards. There's no need to try to squeeze out every penny, and traders who try usually hang on for too long.

Instead of waiting for the exact market top, watch for signs that indicate a correction is coming. Below are three of the big ones. If you see them, consider taking profits and bailing out. If the correction doesn't arrive right away, don't worry. It will.

But first, consider what a top looks like.

What a 'Top' Looks Like

Markets always move in waves. For a top to form, a rally of at least nine months must occur first. Waves may be seen 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 a short rally by historical standards. Between 1942 and 2007, the average bull market was 56 months. The bull market of the 1990s lasted for 113 months. The bull market that started in March 2009 surpassed it.

The nine-month rule still works. It's not the time to take action. But it's the time to start watching for the warning signs.

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 about to head lower.

1. The number of 52-week highs begins to decline, despite growth in the indexes. If the number of 52-week highs declines, it indicates that fewer stocks are working to push the market higher.
2. ​​​​​​The NYSE advance 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 an individual investor's time horizon.

Ultimately, the third signal provides the timing indicator.

It is possible that the first two conditions will appear while the major indexes continue to move higher, although the number of stocks participating in the move will decline. When all the signals align, it indicates that the market is going to have a large correction.

Figures 1 through 3 below show 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 2 shows declines in advancing stocks prior to 2008.

Figure 3 is one of the most telling signals, as the new 52-week highs begin declining dramatically near the end of 2007.

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.