The Myth Of Stock Market Tops
By Mark Hullbert
The Wall Street Journal, September 5, 2017
Many investors are trying to pinpoint the exact day on which the bull market eventually reaches its top. My advice to them: stop. I say that not because it is difficult to predict when the stock market changes direction though that is true, too. But there's an additional reason: stock market tops typically are a gradual rolling-over by the market rather than a sharp trend reversal. Some market averages will hit their peak months before or after others, and individual sectors can behave differently than the market as a whole.
In other words, the stop the top doesn't occur on just one single day, or even in one week or one month. Even if you successfully predict the precise day, or week or month, on which a particular market average hits its top, you can still lose money – or leave a lot of it on the table – because other market averages and sectors likely aren't at their peaks.
A gradual process
This is an important insight not just for market historians. With a stock market up more than 300% from its March 2009 lows, and with the economy and is sick ninth year of recovery from the latest recession, many investors worry that a bear market is overdue. Rather than anxiously trying to determine the exact day when to shift out of stocks, they should instead view market tops is a gradual process in which equity exposure is slowly and deliberately reduced over time. Take the 2007 bull market top. The most widely followed market benchmarks, such as the Dow Jones Industrial Average and the S&P 500 index, hit their highs on October 9 of that year, and that is the date that most market timers record as the "top" of the 2002 to 2007 bull market. Yet the Russell 2000 index, a widely used proxy for the small-cap sector, registered is top on July 13, three months prior. The Dow Jones utility average topped out even earlier, on May 21. And some sectors began their bear markets even longer before; the SPDR S&P Regional Banking ETF, for example, hit it's bull market high in December 2006.
What this means: Pinpointing that October 9 top would not have been very helpful unless you are investing in the S&P 500. In the event you are investing in the average small-cap utility or regional bank, among others, you would have lost money if you had waited until October 9 to sell.
Perhaps the most spectacular example of a divergence at the market top, however, came when the Internet bubble burst. Though the S&P 500 topped out on March 24, 2000, and didn't hit bottom until October 2002, the average small-cap value stock actually rose during that bear market, according to data from University of Chicago professor Eugene Fama and Dartmouth professor Ken French. So small-cap value investors left a lot of money on the table by going to cash during the 2000-2002 bear market.
Divergences that this stark and spread out aren't unusual at market tops, according to David Aronson, a former finance professor at Baruch College and now president of Hood River Associates, a research firm that uses machine learning to enhance stock-market trading systems. "The process of topping out can take a really long period of time, evolving over a year or more," he told me in an interview.
Take the end of the bull market in the earliest 1970s, for example. Though the S&P 500 didn't hit its high until January 1973, major divergences "started to manifest as early as the spring of 1971," nearly 2 years prior, he says.
In contrast, Mr. Aronson adds, "market bottoms tend to be sharper." The bottom at the end of the 2007-2009 bear market is a good case in point: virtually all major averages hit their bear market lows on March 9, 2009. Most individual sectors did so also, and those that didn't mostly hit their bottoms only a few days before or after. As Mr. Aronson argues in a just-published book, "bottoms are easier to identify, in real time, then tops."
The narrow focus
Instead of trying to pinpoint the day of a particular market's average top, therefore, you might want to focus on the prospects for the individual stocks or mutual funds that you own. Bragging rights for calling the top of this or that market benchmark mean little if your stocks or funds start declining months before that top.
One helpful focus would be on internal market divergences between different sectors of the market. A healthy market is one in which most stocks are participating. As divergences emerge and become more pronounced, odds increase that the stocks you own may suffer even if the major market averages such as the Dow and S&P continue rising.
By the same token, you need to be alert to the possibility that your individual stocks will continue to rise even if the major averages began a major decline...
The bottom line is that it is foolish to buy or sell individual stocks on the basis of buy or sell signals generated by the benchmark averages or indexes, or to buy or sell on the basis of market "guru" projections of what the market is likely to do next. A better indication of the health of the market than, say, the buy or sell signals of the S&P 500 would be the percentage of stocks above their 50-day moving average or the percentage of stocks with a rising 10-day moving average, both of which are reported under "S&P 500 Data" on the "Stock Market Review" page of this Website. With regard to individual positions, it makes much more sense to focus on buying stocks on a trigger event if the stock is in a good setup configuration. That will make a big difference in determining timely entry points. Then, use a disciplined sell strategy or a trailing stop loss to protect assets when the stock (not the market) begins a significant decline.