How to forecast a stock-market top

4/19/2011 2:43 PM ET.
By Mark Hulbert, MarketWatch.

How to forecast a stock-market top

A Wall Street research firm is tracking four key indicators for signs that the bull market is on its last legs. Here's what to look for.


How will we know when the bull market is coming to an end?

This is a timely question, given the extraordinary crosscurrents buffeting the market. Some advisers contend that the bull is alive and well, while others assert that the bull is living on borrowed time.

For insight, I turned to Ned Davis Research, the quantitative research firm, which monitors a basket of indicators to help determine when a market top is imminent.

Nearly two years ago I turned to the company for help in answering this very question. At the time, many were convinced the rally was but a bear-market correction. But Ned Davis, upon analyzing various indicators of a potential top, concluded that the bull market had further to go.

What does Davis' firm say now?

Ed Clissold, the global equity strategist at the company, said there are worrisome signs on the horizon, but the company is giving the bull the benefit of the doubt.

In assessing when the bull might end, Clissold said, the company has identified four major categories:


Valuation
Though stock valuations aren't at such an extreme as to cause this category of indicators to flash a sell signal, there are causes for concern, Clissold said.

One of these, according to a letter Ned Davis sent last week to institutional clients, is that "profit margins on the S&P are at record highs. . . . Using data back to 1954, very high profit margins, on average, have not been bullish for stocks, because the series is very mean-reverting."

Davis also was concerned with the cyclically adjusted P/E ratio made famous by Yale professor Robert Shiller.

At the same time, however, Clissold referred to other valuation measures that suggest stocks are not particularly expensive, such as the P/E ratio based on 12-month earnings (as opposed to the 10-year average Shiller prefers).

All in all, a split decision on valuation. As Davis wrote earlier this week: "I can certainly understand the bullish stance of those who argue stocks are still reasonably priced, based upon current earnings. Yet, I don't think that presents a complete picture of potential risks. I am just providing the evidence for clients to make their own decisions."

Sentiment
This is the one category of the four that, in Davis' opinion, comes closest to yelling "sell."

Davis maintains two sentiment indices, one of which is well into the zone of excessive optimism; the other borders on that zone.

On contrarian grounds, that is worrisome.

Market breadth
This category is perhaps the most bullish, according to Davis.

"One of the key characteristics of a major top in the stock market is considerable divergences," Davis wrote, and there are few signs of that.

Davis tracks the "High Low Logic Index," which represents the lesser of new 52-week highs or new 52-week lows as a percentage of all issues traded. The index traces its roots to a metric created three decades ago by Norman Fosback.

In his book "Stock Market Logic," Fosback describes the rationale behind the metric: "Under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows -- but not both.

"As the (High Low) Logic Index is the lesser of the two percentages, high readings are therefore difficult to achieve," Fosback continued. "When the Index attains a high level, it indicates that the market is undergoing a period of extreme divergence. . . . Such divergence is not usually conducive to future rising stock prices."

Currently, according to Davis, the index is bullish, at 2.4%. At the stock market top prior to the 2007-2009 bear market, it rose to close to 6%. The only other time in recent decades the index got this high was in early 2000, right before the popping of the Internet bubble.

Interest rates
This category, like valuation, is providing some causes for concern, according to Clissold, but is not yet bearish.

The concerns derive from higher rates, which have caused some of the firm's interest-rate-trend indicators to enter bearish territory. However, Clissold said he doesn't think that these concerns yet amount to a "screaming sell signal."

One straw in the wind to look out for, he said, is the 10-year Treasury yield rising to around 4.25% -- three quarters of a percentage point above its current level.

Summing up the situation
The bottom line, according to Davis?

"There are a number of things about this market that concern me as a risk manager," he said. Still, all things considered, for now, he "leans bullish."