Are We Approaching a Market Top?

With so much economic and political uncertainty swirling around us right now, it's little wonder that investors are just waiting for the other shoe to drop. And while the market has rebounded strongly since its bottom in March of 2009, we know that the rally can't go on unabated forever. That's left a lot of folks keeping one eye open for signs that the market's upward climb has run out of steam.

Peering over the ledge
A recent MarketWatch column noted that a new study by Ned Davis Research provides evidence that may warrant a yellow light in today's market. The study looked at stock performance in the final three months of each bull market going back to the early 1970s. Examining sector performance, the data showed that financial stocks and utility stocks tended to underperform the market in the last months leading up to market peaks while consumer discretionary and consumer staples names outperformed. So how does recent sector performance look in comparison?

Source: Morningstar.com.

So with the notable exception of utilities, current sector performance more or less lines up with the pattern the Ned Davis study suggests we are likely to see in the waning days of a bull market. So does this mean a sell-off is right around the corner?

The long-term view
Well, the first thing to keep in mind is that calling a market top or bottom is extremely difficult for anyone to do with any kind of precision on a regular basis. And it's also very difficult to make a pattern out of just three months of data. Just as you wouldn't (or shouldn't!) pick investments based on short-term performance, you shouldn't draw conclusions about the direction of the economy based on just a few months of data releases, and you really shouldn't make predictions about the future direction of the stock market based on what stocks have been doing in the past three months.

This is important because odds are you could probably find more than one 3-month period of time in the past decade or so when the "rally-ending" pattern showed up right in the middle of a bull market. For example, in the three-month period from March to May 2004, here were the trailing returns for the same sector funds and the S&P 500 Index:

Source: Morningstar.

Of course, from that point on the S&P 500 posted another cumulative 46% gain before the market top back in October 2007. So this pattern of sector performance isn't a perfect omen of a market top, even if it is a fairly reliable indicator. And remember, the solid performance of the utilities sector in recent months means all the stars aren't aligned exactly this time around anyways.

Expect the best, prepare for the worst
But more to the point, is there a possibility that the current bull market is getting a bit long in the tooth? Absolutely. We've come very far very fast and have almost certainly already seen the biggest gains following the market drop that we're going to see. And by most measures of valuations, it's hard to argue that the market represents a screaming bargain at its current prices. So investors should moderate their expectations for the coming years. But this doesn't mean going into hiding and avoiding stocks.

If you're already in retirement or close to it, you should make sure that any money you may need to live on in the next five years is not in the stock market. That money should be in cash, CDs, or short-term bonds that are easily accessible to you and not at risk of loss if the stock market takes a dive. But for investors who still have a decade or three until they retire, it just doesn't make sense to take the chance of missing out on the market's long-term gains in an attempt to avoid a short-term correction. That means staying committed to your long-term asset allocation.

If you fall into this latter group, you should be able to safely ride out any downturns or bear markets that occur long before you need your money. Make sure your portfolio is appropriately diversified, both across market caps and geographically, and take careful note of where you are directing any new money or new retirement contributions. Avoid loading up on the overpriced commodity or fixed income sectors and instead think about what areas of the market are offering more relative value: namely high-quality, dividend-producing large-caps. These stocks won't be insulated from a market drop but their generally cheaper valuations mean that risk is lower here than in many other corners of the market.

Ultimately, no one market signal or valuation measure will tell you exactly when the market is going to peak. But by keeping a long-term focus and positioning your portfolio to take advantage of the most attractive investing opportunities today, you won't need to worry about what short-term twists the market has in store for you.

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