Leading indicators of a stock-market top

CHAPEL HILL, N.C. (MarketWatch) — ‘A top in the stock market may be closer than you think.

That, at least, is the disturbing conclusion that emerges from an analysis of the relative performance of the market’s various sectors prior to tops. The sectors that typically shine during the last months of a bull market have done quite well in recent months, while at least some of the sectors that typically do poorly have been struggling.

In drawing this conclusion, I am relying heavily on a study conducted early last year by Ned Davis Research, entitled “Leading Sectors for Calling Bull Market Peaks.” The study focused on performance over the last three months of each stock bull market in the U.S. since the early 1970s.

The study’s finding: “Financials and utilities have tended to underperform in the months leading up to bull market peaks, while consumer discretionary and consumer staples have outperformed.”

Unfortunately, in the case of 3 of these 4 sectors, returns over the last three months are consistent with a top being formed. (The table below reports returns, courtesy of FactSet.)

Notice the recent market-beating performance of both of the sectors that typically outperform prior to market tops. And notice also the market-lagging performance of one of the two sectors that typically lag prior to tops.

The lone sector that is the exception to a bearish conclusion is financials. And I’m not sure how much weight to place on its performance, since an argument could be made that it’s being artificially propped up by the Federal Reserve’s policy of keeping interest rates low — a policy that virtually assures large profits to financial institutions.

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The last time I employed this analysis in one of my columns was in May 2011, some 18 months ago. Like now, the conclusion that emerged then was that, in 3 out of 4 cases, prior three-month sector performance was consistent with a top being formed. ( Read my May 18, 2011, column. )

And, sure enough, the market at that time was embarking on a serious correction, if not an outright bear market. By the time the market bottomed in early October of last year, in fact, the S&P 500 index SPX -0.41%  was down more than 20% from its high set in the spring — thereby satisfying at least one of the standard definitions of a bear market.

 

 

A single indicator is not enough to spell a market’s future direction, whether bullish or bearish.

Needless to say, the analysis I present here doesn’t constitute a guarantee that the market will suffer a similar fate this time around. No one should ever base their market forecast on just one indicator.

Still, the ominous parallels to prior tops are sobering indeed. ‘

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