A healthy stock market fires on all cylinders, and Wall Street certainly has been doing that recently. On Jan. 20, for example, almost all of the major stock market averages jointly closed at new all-time highs. In addition to the Dow Jones Industrial Average
and the S&P 500
other indices closing at new all-time highs that day included the Dow Jones Transportation Average
the Nasdaq Composite
the S&P 400 Mid-Cap
and the Russell 2000
Contrast these recent new highs with the U.S. market’s high in 2007, prior to the Great Financial Crisis. Though the Dow and the S&P 500 both reached high points on Oct. 9 of that year, the Russell 2000 hit its high on July 13 of that year, while the Dow Transportation Index topped on July 19.
This points to a key feature of the typical bull-market top: It doesn’t happen on a single day. Tops tend to happen gradually, as one segment of the market rolls over and then another. There are exceptions, particularly when external “black swan” events pull the rug out from underneath the market, such as the bull-market high in February 2020, which was brought about by the escalating pandemic.
Focus on divergences
Given that a sign of a healthy market is wide participation, it’s not an accident that most stock-market timing theories try to identify market tops by measuring divergences. A good example is the Dow Theory, which is the oldest market timing system in widespread use today. It keys off the actions of the Dow Industrials and the Dow Transports, using a divergence between the two as a sign of a potential turning point in the market. The Dow Theory currently is sending a bull-market buy signal.
One market timer who pays particularly close attention to internal market divergences is Hayes Martin, president of Market Extremes, an investment consulting firm that focuses on major market-turning points. I devoted a column to Martin’s analysis in May 2020, when — like now — there was widespread participation in the bull market. I reported then that “the stock market is stronger than even the most bullish investors believe.” The S&P 500 since then has gained more than 20%. (Martin does not have an investment newsletter; my newsletter-tracking firm does not audit his investment performance.)
In addition to focusing on the major market averages, Martin also looks for divergences that emerge between different market styles, factors and industries.
The divergence that his research has found to be the most accurate early warning of a major market top occur when small- and microcap stocks are weak and large-caps are strong.
Divergences have emerged in recent trading sessions within the large-cap sector, Martin says. Though such divergences are not as worrisome as those between the small- and large-caps, they are concerning and indicate that a 10% to 15% correction is possible, he adds. Making such a decline even more likely, he says, is the extreme bullish sentiment that has materialized in recent sessions — reminiscent of the irrational exuberance at the top of the internet bubble.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com