Here’s how a bull market acts when a major peak is near

There’s no reliable way to predict when or exactly why a bull market will finally end. But how the market will behave when a peak is closely approaching tends to follow some broad patterns that can be tracked by investors.

Longtime students of the market cite a handful of conditions that typically emerge when the risk of a severe downturn is high. At an important top in the indexes, key leadership sectors have usually turned to laggards, credit markets have grown more hostile, market volatility has been elevated for several months or more and investor sentiment frequently has gone from overconfident to suddenly fearful.

Leadership

Doug Ramsey, chief investment officer at Leuthold Group, tracks an array of sectors and indicators to discern the strength of a market’s prevailing trend. Ideally, the market is “in gear,” supported by healthy risk appetites and implying an improving economy. He monitors such indexes as the Dow Jones Transports and the Utilities, Russell 2000, financial stocks, S&P Industrials and Materials and the equally-weighted version of the S&P 500.

“At a major bull market top,” he says, “we should expect to see most of these indexes lagging the Dow Jones Industrial Average and S&P 500.”

The good news, for now, is that all of these have managed to notch a new all-time high in the past month. “It’s therefore very difficult to argue that the market has narrowed from either a thematic or capitalization perspective,” Ramsey says.

Chris Verrone, technical strategist at Strategas Research, is most closely focused on the S&P 500’s industrials, which he says has the tightest statistical link to the broader market. If those start to roll over, [it] might be a signal something is changing.”

As the chart here shows, though, that is not yet the case for any of the cyclical bellwether sectors.

Source: FactSet

Interestingly, multiple market analysts suggested that traditional measures of market “breadth,” or the running tally of rising versus falling stocks, might not be as useful an indicator as in the past – perhaps because so much of the money flow into stocks goes through index funds, or because automated trading programs dominate the action.

Credit Conditions

Corporate bonds have led the way for stocks this cycle, as usual. Stronger appetites for corporate debt have compressed their yields relative to Treasuries, which clears the way for equities – adjacent to corporate bonds on the collective private-sector balance sheet – to be revalued higher.

High-yield bond spreads have been steady at fairly narrow levels in recent months. The lowest junk-bond yields of this cycle were seen in mid-2014, and they surged in the energy-and-industrial crash of 2015 into 2016. Right now they are not signaling much imminent danger of recession or financial contagion, which is a big factor keeping gauges of financial conditions quite loose and friendly toward stocks.

Some have argued that credit markets won’t be a reliable leading indicator this cycle, perhaps because central banks have had a big role in buying debt globally. Yet it’s hard to see the bull market falling apart in a dramatic way without a good bit more stress showing up in debt-related measures of liquidity.

Source: FactSet

Volatility

Yes, the markets have been uncommonly calm all year, with the narrowest average daily range for the S&P 500 in more than a generation – and one of the longest periods without even a 3 percent pullback in decades. The VIX has hovered much of the year near 10, around half its long-term average level.

Is this the clichéd calm before a major storm? Well, at some point the peace will be broken, by something. But markets are rarely so quiet at the very peak. Stocks tend to get jumpy and emotional in both directions in the final stages of a bull market, before the peak price is in.

As this chart of the VIX shows, this gauge of options-based expected volatility started trending higher some ten months before stocks peaked in October 2007 before the prior major bear market.

Source: FactSet

Sentiment

This is a tricky call. It’s common to hear bullish investors argue that bull markets don’t end until the broader public has become excited about speculating in stocks — when greed has fully displaced fear. Right now, retail-investor allocations to equities is pretty elevated, high valuations or not, and Charles Schwab recently cited a record pace of new-account openings.

More broadly, though, euphoria is largely absent — though it was also hard to argue the little guy was ebullient over stocks at the 2007 top either, more content to flip houses in that cycle.

Ed Clissold, chief U.S. equity strategist at Ned Davis Research, says to watch the way investor mood changes with minor market dips.

“Our sentiment composite indexes have shown pessimism [rising] on small corrections,” he says. “If that changes and they show optimism after a pullback, it would be a sign of a top.”

There is no magic formula for handicapping an impending severe correction or bear market. Market relationships are always evolving and are open to varying interpretations. These patterns amount simply to the atmospheric conditions that might generate a destructive storm, but the path and strength of any disturbance is unknowable in advance.

Sure, valuations are rather high, with equity returns quite good for the past six years and possibly “as good as it gets” conditions already seen in the breadth of global economic growth and corporate credit. And, of course, a more routine setback of 5 percent or a bit more could strike at almost any time – for any set of reasons, or no obvious ones at all.

Still, if these broad guidelines informed by many past market cycles have merit, it would seem investors right now needn’t be on high alert just yet for the ultimate demise of the bull.