The Telltale Signs of a Market Top. What to Look For.

The Wall Street bull in New York’s Financial District. (Spencer Platt/Getty Images)

Bull-market tops on Wall Street aren’t simply the mirror opposite of bear-market bottoms.

The former tend to be more gradual and less dramatic, and therefore are often overlooked in real time. Bear markets tend to be more violent, with the market plunging as the few remaining bulls throw in the towel.

That’s important to keep in mind as you assess whether the bull market hit its top in late October —or is about to go higher still. If you believe that tops are the opposite of bottoms, you might conclude the bull market is alive because of how gradual its behavior was in the weeks leading up to that high.

This contrast is illustrated in the accompanying chart, which is based on bull and bear markets since 2000 in the calendar maintained by Ned Davis Research. The light-blue line represents the S&P 500 index’s average behavior over the 50 trading days before bull-market tops, while the dark-blue reflects the period before bear-market bottoms. In each case, the S&P 500’s level on the day of the top or bottom is normalized to 100.

Notice how sharply the dark-blue line for bear-market bottoms declines before bottoms. The S&P 500 on average falls by nearly 20% over the 50 trading days before bottoms. Market tops are hardly the mirror opposite, as you can see. Over the comparable period before tops, the S&P 500 rises only modestly.

Sentiment at Tops and Bottoms

Investor sentiment also behaves far differently at tops than bottoms. The predominant sentiment at tops is exhaustion, which is why bull markets typically end in a whimper rather than a bang. At bear-market bottoms, in contrast, the predominant sentiment is bone-chilling fear, which is why bottoms tend to be more violent and intense.

Consider stock market timers’ average recommended equity exposure levels before bull-market tops and bear-market bottoms since 2000, as plotted in the chart below. The chart relies on a sentiment index my auditing firm calculates daily, known as the Hulbert Stock Newsletter Sentiment Index, or HSNSI, based on the average recommended stock exposure among dozens of short-term market-timing services that we monitor. Prior to the market tops, the HSNSI fluctuates in a fairly narrow range, with no overall trend. Not so at the average bear-market bottom, when the HSNSI hits its lowest level very close to the day of the bottom.

As you can see from the chart above, the HSNSI on the day of the average bull-market top is barely higher than where it was 50 trading days earlier. On the day of the average bottom, in contrast, the HSNSI is 46 percentage points lower.

The Current Market

To be sure, no two tops or bottoms are exactly alike. So using these historical averages to gauge the health of the market is more art than science.

That said, the recent behavior of the S&P 500 and market-timer sentiment is consistent with the patterns exhibited before past market tops. The stock market was relatively calm in the weeks leading up to its late-October high, in contrast to the parabolic increase that you’d expect if tops were the opposite of bottoms. Though the S&P 500 did rise over the weeks leading up to that high, its rate of increase didn’t stand out compared with its gains in recent years, and its volatility was actually below its recent-year average.

The sentiment data tells a similar story. Though the HSNSI was elevated on the day of the S&P 500’s late-October high, on that day it was just six percentage points higher than where it stood two months prior. There was nothing to suggest that compared with other occasions in recent years, the market timers were becoming unusually exuberant.

These parallels don’t guarantee we are in a new bear market, of course. But they remind us that market tops are rarely detected in real time.

Mark Hulbert is a regular contributor to Barron’s. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

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