How to Survive When the Bull Market Tops Out

The S&P and Dow Jones are making record highs, and U.S new home sales are at their highest levels in seven years. What could go wrong?

The market is overheating. Which indicates that a correction is in the near future.

In March 2009, the S&P hit a decade-low 676. The stock market was in a panic.

Now after a nearly seven year long bull run (where prices are rising) the S&P 500 is above 2000 and people are starting to get itchy. The U.S. market has run its course and a recession might be in the cards.

Reports of record M&A activity (mergers & acquisitions) and ailing corporate foreign profits, begs the question on the mind of any investor: are we at a market top?

What is a Market Top?

A market top, simply defined, is the highest point of the stock market. It is hard to pick out a market top as it is happening. The difficulty is that investors cannot know for certain whether the market has reached its highest point or if it will continue rising.

That’s why experienced investors turn to indicators to help them out.

For example, M&A markets tend to get overheated near market tops. U.S. M&A activity recently surpassed the 2007 peak of $1.3 trillion, reaching $1.4 trillion in 2014 – representing a huge increase on the $900 billion in deals brokered the previous year. Remember that the previous peak was followed by the global recession in 2008 and you see why this might be important.

m1

Source: www.valuewalk.com

But who knows what will happen in 2015. M&A activity could continue for years more before we see any meaningful correction in the stock market. Indicators are useful but are not gospel.

Others like to look at the average breadth and length of previous market runs to get a sense of where the current market push lies.

How Does Today’s Bull Market Stack Up?

Since 1932, there have been 12 bull markets, ranging in duration from 14 months to 148 months, with an average of 60 months. The current bull market, at 72 months of age, is decidedly middle-aged. It may not be ready to set off into the sunset just yet but it is definitely closing in on its late stage.

m2    Source: www.blogs.cfainstitute.org; *data current to December 2013

The 11 previous bull markets gained between 74% and 582%, with an average gain of 185%. The current bull market has gained about 250% since March 2009. That means an investment of $10,000 in March 2009 would be worth $25,000 today. The return of 250% puts this bull market in third place behind December 1987-March 2000 and June 1949-August 1956. Again we see that today’s market is quite mature.

Once more it is hard to say definitively that the stock market is ready to take a plunge. Statistics mean nothing to the individual. What’s to stop this current bull market from breaking record after record? What’s stopping it from ripping past the previous record of a 582% gain?

All bull markets end, but not because they become long in the tooth or people simply feel that it is “time”. Bull markets end because of excesses that build up over time; just like how the Great Recession of 2008 was the cause of excesses built up in the housing market and an overleveraged banking system.

That truth is that it is hard to predict where these excesses will build. Americans are more confident about the economy than ever. Hiring is up and unemployment is down. Unemployment has fallen to 5.5% from 10% in 2009 and the plunge in oil prices has given the average American a kind of unexpected tax break, putting more money in their pockets. The Federal Reserve has also played its part, incentivizing investors to invest in equities by keeping the returns on bonds extremely low.

Another indicator that people often turn to is investor sentiment, which has, over the years, been a fairly reliable indicator of an approaching market top. It won’t give you the exact timing but it can tell if a market is vulnerable or not.

At market tops there is unanimous bullish sentiment. Money managers are confident and fully invested. When there is no money left to be invested you are at a market top. As word gets around, people start selling, setting off a bear market.

m4

Source: ycharts.com

Looking at the chart above it would seem that there is no danger ahead. Bullish sentiment has surged 11 percentage points to 38.4 but is actually lower than its long-term average of 38.8. Sentiment has been in a downward trend since the end of 2014, signalling that the bears are coming out of hibernation. That would suggest that investors are a bit nervous. It might be that investors are waiting to see what impact the Fed will have when they announce their intentions in regards to interest rates today.

So the question remains, are we at a market top?

Answer: hard to say for sure, but we’re definitely near the top. If I had a lot of money in the market I would start to prepare for a stock market reversal by lowering my exposure while simultaneously keeping track of a host of indicators. I would look at the VIX indicator to get a measure of how anxious the market is. I would pay very close attention to the Fed and what interest rates are doing. I would also want to look at how money is moving across the world. If the return of U.S. treasuries rise then it is very likely that money will start to flow into the U.S. from other countries, propping up the economy and furthering a bull run.

The last thing I would do is look at what the pros are doing. For example, Warren Buffet has been increasing his exposure to cash, meaning he is taking a more conservative approach that other investors might be smart to follow.

As they say: better safe than sorry!

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