Wall Street on lookout for signs of market top
NEW YORK — With the graying bull market now five years old and stocks trading in record-high territory, Wall Street is on the lookout for classic signs of a stock market top.
"The time to fix the roof is before it rains," says Brad McMillan, chief investment officer at Commonwealth Financial. "Investors should identify ahead of time the things in the past that have signaled a significant market decline, and keep an eye out for them."
Searching for bear market warning flags is back near the top of investors' to-do lists. Who can blame them? The prior two bull markets were big ones that ended badly.
At the top in 2007, stocks were levitating to record highs, and fixer-upper homes were selling at mansion prices. It ended with the 2008-2009 financial crisis, the Great Recession and a stock market drop of nearly 57%.
At the 2000 peak, Internet stocks went parabolic. Speculators were counting mouse clicks rather than profits. The end was just as ugly, as dot-com stocks crashed, ending the biggest bull market in history and ushering in the "Lost Decade" on Wall Street.
"I am waiting for the market to trip up," says Jack Ablin, chief investment officer at BMO Private Bank. "There are a bunch of dials I watch and monitor."
Does he see any threats on his radar? "Maybe a yellow signal or two, but i don't see any imminent danger or threats out there" — at least not yet, he says.
Still, investors who want to avoid a fatal third strike that could blow up their portfolios should keep an eye out for the following signs of froth, irrational exuberance, buying frenzies and other tell-tale signs of a market top, says Jason Trennert of Strategas Research Partners, who listed some classic topping signs in a report to clients.
1. Market melt-ups. Market melt-ups, or blow-off tops, could signal trouble ahead. In 2000, for example, the Nasdaq composite rallied 88% from Oct. 19, 1999, to its all-time high of 5048.62 on March 10, 2000. Similarly, the S&P 500 rallied 11.3% in an eight-week span leading up to its October 2007 peak.
While last year's 30% gain was spectacular, because returns were spread out over a full year and have been followed up by a relatively flat market in 2014 takes this off the worry list — at least for now.
2. Heavy inflows into U.S. stock funds. Bubbles often coincide with Main Street investors throwing every cent they own into the stock market. In the first quarter of 2000, $101 billion flowed into domestic stock funds, the largest quarterly inflow on record, according to the Investment Company Institute. For the year, $259 billion flowed into U.S. funds. The buying frenzy coincided with the Nasdaq top. The tech-dominated index ended 2000 down 40%.
In contrast, Main Street has pretty much sat out this bull market. Last year, net inflows to U.S. stock funds totaled just $18.4 billion despite the market's nearly 30% rise, ICI data show. Since the start of 2008, mutual funds that invest in domestic stocks have seen outflows in 52 of 72 months, or 72% of the time.
"We won't see a mania like 2000, but we are seeing more retail investors move money back into the stock market," says McMillan. While irrational exuberance is absent on Main Street, many clients who missed out on the bull are again looking to "dial up risk," which bears watching. he says.
3. Robust M&A and IPO activity. When stocks are rising in value, companies view them as a cheap currency that can be used to snap up other companies. Similarly, a hot market often entices start-ups to go public and list their shares on stock exchanges for the first time while demand for stocks is brisk and market sentiment is bullish.
The number and value of M&A deals soared around both the 2000 and 2007 stock market top. And the heyday for initial public offerings for IPOs occurred in 2000 at the height of the tech-stock bubble. While M&A activity has picked up, the 10,095 deals totaling $1.18 trillion last year, far below the $1.5 trillion in deals at the prior two tops, according to data from Dealogic.
Similarly, while the 222 IPOs in 2013 topped the 213 of 2007, it was still down about 50% from the record 400-plus IPOs of 2000, Renaissance Capital data show.
Despite the buzz surrounding Twitter's recent IPO and massive mergers such as the $45 billion Comcast-Time Warner cable marriage, the recent surge is not enough to warrant a bull-market warning flag yet, Trennert told clients.
4. Rising rates, falling profit revisions. When interest rates are rising and Wall Street analysts start to dial back their earnings estimates for U.S. companies, a warning flag should go up. Leading up to the tech stock crash in early 2000, then-Fed chairman Alan Greenspan raised short-term interest rates from 4.75% in late 1998 to 6.5% in May 2000. A rise in rates also hurt stocks leading up to the 2007 market top.
Downgrading profit estimates is another negative for stocks, especially with the stock market trading back around its long-term price-to-earnings ratio. Earnings must accelerate to justify prices, but in the past 90 days, earnings estimates for the next 12 months have fallen 1.7%, says Gregory Harrison, an analyst at Thomson Reuters.
"A declining number of upward earnings revisions bears watching," Trennert told clients.
5. Buying stocks on margin. Using borrowed money to buy stocks is a sign that investors think the outlook for stocks is bright. In January, a record $451.3 billion in margin debt was reported by the New York Stock Exchange. That's more than the $345.4 billion near the peak in October 2007 and the $278.5 billion borrowed against stock portfolios back in March 2000.
Rising margin debt is a "worrisome sign," says McMillan. The borrowed money fuels stock purchases and keeps the market momentum going. The problem is that when stocks head south, investors have to repay those loans at the same time the value of their stock portfolios is declining.
"Margin debt is like using a mortgage to buy stocks," says McMillan. "Often, investors have to sell stocks to pay off their margin debt. And that drives down prices."